Shorting for the 21st Century

Inverse funds allow investors to place bets on predictions of a drop in stocks

Trouble in the economy and turmoil in the markets in 2007 rocked a lot of investment portfolios. But many people took advantage of new tools that made it easier to hedge against losses—and profit from predictions of pain ahead.

Inverse funds, either in the form of mutual funds or exchange-traded funds (ETFs), allow investors to place bets that the pain will continue. The funds use financial engineering techniques to move in the opposite direction of a particular index. A 1% drop in a financial sector index, for example, translates into a 1% gain for an inverse financial fund. Some of these vehicles are built to double up, giving you a 2% gain for a 1% loss in the index. Among the outcomes inverse investors can bet on are more losses in the financial sector, a collapse in the supercharged Chinese stock market, and falling share prices in the U.S.

Inverse funds are a 21st century wrinkle on a very old practice—selling short. With short-selling, investors borrow a stock from their broker, sell it, and then (with luck) buy it back later at a lower price. That practice still flourishes, but it's a stock-by-stock transaction. With the inverse funds, investors can effectively short a whole basket of stocks. Unlike the setup with a traditional short sale, if you bet wrong, you can't lose more than your original investment.

There has been tremendous interest in such instruments, says Michael Sapir, CEO of ProShares, the leading inverse ETF manager with 35 funds betting against a host of indexes, sectors, and international markets. Since its inverse ETFs first appeared in June, 2006, investors have plowed $7.6 billion into the funds. Thanks to 2007's financial turmoil, ProShares' UltraShort Financials ETF (SKF) has been a big hit, attracting more than $1 billion in assets, racking up a 37% gain, in its first 11 months. UltraShort FTSE Xinhua China 25 (FXP), a fund that aims to gain 2% for every 1% drop in the index, attracted $305 million in the first two weeks after its November debut. The firm's total lineup of short funds contains $9 billion in assets. Its smaller ETF competitor, Rydex (RFS), has $1.6 billion in inverse funds.

Many individuals use inverse funds to hedge. Let's say you have an investment in China, which you see as a great long-term growth opportunity, but you're worried about a market drop in the coming months. You can invest a small part of your portfolio in the China inverse fund. Although not a perfect hedge, the fund will tend to move in the opposite direction from your regular Chinese investments and limit your losses if China's market crashes.

Used like this, inverse funds are a far better strategy than taking "the sledgehammer approach" of dumping stocks outright—especially when selling can trigger unwanted taxes, says Chris Guarino, a financial adviser at Smith Barney (C).

For investors interested in taking more risk for more potential return, inverse funds can also be used to put money behind a hunch. Think 2008 will be tough for U.S. stocks? Buy a fund that shorts the Standard & Poor's (MHP) 500-stock index. Think consumers will slow their spending in 2008? Buy an inverse retail-sector ETF.

Because most inverse bets will be for limited periods, they do tend to trigger higher, short-term capital-gains taxes. And the fees are high, a 0.95% expense ratio for most of ProShares' inverse ETFs, compared with 0.1% or lower for many long-only ETFs matched to broad indexes such as the S&P 500.

And keep in mind that when you put money into one of these inverse vehicles, you need to think about when to exit. These are not buy-and-hold investments. After all, over the long term, stocks tend to go up.

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