This post was written by Jeff Fang of Financial Pupil. Please note that contributing opinions and claims are that of the author. They are not always in strict alignment with our own opinions. – Joe
ETFs That Short the Market are funds that benefit from the stock market dropping. Otherwise known as inverse or bearish ETFs, these funds rise in value during a bear market and fall during a bull market.
How most inverse ETFs work is through futures contracts. Let’s say you have a financial instrument (like a stock) which you think will go down a lot. A futures contract lets you set a price to buy/sell the stock at a future date.
Assuming you think the stock will drop, you can set a price to sell the stock at a future date. If you’re right and the stock does drop, you’d be able to buy the stock at the lower price and sell it for the predetermined higher price, earning you a tidy profit.
Inverse ETFs use these future contracts to “bet against the market.” If the stock market falls, usually an inverse ETF will rise.
Why Inverse ETFs
So, why inverse ETFs in the first place? Well, an inverse fund provides investors with a diversified way to short the stock market. Going along the lines of the ETF vs stock debate, inverse ETFs have the advantage over individual stocks of not being highly concentrated.
If you make a bet that’s wrong on an individual stock, you’ll lose a whole bunch of your investment. However, if you have an ETF that holds hundreds of stocks, one wrong pick won’t affect it too much.
It’s true, some mutual funds out there also express bearish sentiment on the market. But a short ETF will typically carry lower costs and higher liquidity than a mutual fund. In terms of management, most mutual funds don’t perform nearly as well as the market, so the passivity in ETFs could be a good thing.
On top of that, an inverse ETF is an alternative way to short the market than actual short selling. With short selling, you run the risk of margin calls since you need to go on margin. Furthermore, your gains are capped (the stock can only go down to 0), but your downside is unlimited (it could go to the moon).
Unlike short selling, when you purchase an inverse ETF, you’re actually buying a fund… so you won’t have to worry about margin calls. Plus, the diversified nature of ETFs protects you from “unlimited downside”.
Who Should Buy Inverse ETFs
Because gains compound more than losses, an inverse ETF is not a good long term investment and should only be used for short term predictions. In the near term, ETFs that short the market will return about the opposite of the market. But over time, because of the compounding of daily returns, a disconnect may occur.
For this reason, you should only purchase inverse ETFs if you believe the stock market will drop significantly and very soon. On top of that, you should probably only allocate a small part of your portfolio to inverse ETFs (it’s increasingly harder to time the market based on past performance).
Passed these two qualifications? Then you’re ready to profit off-market declines, and these are the 5 best ETFs to do it through.
How to Decide Which ETFs to Buy
Not all ETFs are created equal, and it’s no different for ETFs that short the market. When looking at which ETFs to buy, it’s important to do your due diligence. There are a few metrics that you’ll want to pay close attention to:
Expense Ratio / Fees: The expense ratio is the mandatory fee that you need to pay the fund for managing your money. It’s usually shown as a percentage which represents the percent of your invested amount which will be paid. Short ETFs usually carry higher fees than normal ETFs so be sure to do a thorough comparison.
Leverage: When it comes to short ETFs, they don’t all correlate directly to the index they’re tracking. Most ETFs will be -1x (they’ll return the opposite of the daily returns of the underlying index) but some are -2x and some are even -3x. The higher the leverage the more the risk so pay attention to whether an ETF is leveraged or not… and how much.
AUM / Issuer: The Assets Under Management and issuer of the fund are both votes of confidence for the fund. If the AUM is huge, then a lot of people believe in the ETF (but it might be saturated). Likewise, some people like to invest with established issuers while others want to place their bets on up and running funds. Nevertheless, these two metrics are crucial to look at before investing in a short ETF.
Average Daily Volume: This lets you know how much the particular ETF is being traded. It’s a good proxy for how liquid your investment will be. You don’t want to toss money into a short ETF, realize you want to pull out, then find out the fund is so illiquid that you need to pay a huge spread.
Past Performance: Like analyzing normal stocks, when looking at inverse ETFs, past performance matters. The one caveat is that these funds weren’t built for long-term performance; they were built for 1-day trading. So when looking at performance, one way to do it is to isolate certain eventful days (perhaps sometime in March 2020) and see how each ETF fared.
The 5 Best ETFs That Short the Market
Here are 5 of the best and most popular ETFs that short the stock market.
- Assets Under Management: $609M
- Expense Ratio: 0.91%
- Average Daily Volume: 16M
- Total Return: -99.26%
- Issuer: ProShares
ProShares UltraShort S&P is an amplified inverse ETF that tracks the S&P500. In other words, on a daily basis, it aims to perform the opposite of how SPY is performing (but 2x). So in theory, if the S&P500 falls by 5% on a particular day, SDS will return +10%. Incepted in 2006, UltraShort has been one of the most popular short ETFs on the market.
- Assets Under Management: $368M
- Expense Ratio: 1.09%
- Average Daily Volume: 6M
- Total Return: -99.98%
- Issuer: Direxion
Known for its leveraged ETFs, Direxion created SPXS in 2008 at the peak of the real estate crisis. The Daily S&P Bear 3X does exactly what it sounds like. It returns -3x of the S&P500. If the S&P500 falls by 5%, SPXS will rise by 15%. As one of the most aggressive inverse ETFs out there, you could make a ton of money if you’re right, but also lose a LOT if you’re wrong.
- Assets Under Management: $348M
- Expense Ratio: 0.95%
- Average Daily Volume: 1M
- Total Return: -92.33%
- Issuer: ProShares
Created in 2007, the ProShares Short Russell 2000 aims to provide a single day 1x inverse of the Russell 2000. If RUT (the Russell 2000) returns 5%, RWM will return -5% and vice versa. Heavily concentrated in financials, healthcare, and IT, the fund is for those who really believe something bad is going to happen to the world.
- Assets Under Management: $51M
- Expense Ratio: 3.36%
- Average Daily Volume: 50K
- Total Return: -90.54%
- Issuer: AdvisorShares
Incepted in 2011, HDGE aims to do something different from another inverse ETFs. Instead of tracking an index (like Russell or S&P), HDGE shorts individual stocks and equities to meet its investment objectives. They generally look for companies that have really bad earnings or have aggressive accounting practices. That being said, taking short positions is more expensive than trading futures which results in a higher fee (expense ratio) compared to another inverse ETFs.
- Assets Under Management: $236M
- Expense Ratio: 0.95%
- Average Daily Volume: 685K
- Total Return: -88.00%
- Issuer: ProShares
Created in 2006 and tracking the Dow Jones Industrial Average, DOG is arguably the “least aggressive” of these ETFs. DOG is an ETF that aims to return a daily -1x of the Dow Jones. With Dow Jones being one of the least “high-tech” indexes out there, making a bet against it might be safer than a bet against something like Nasdaq. In other words, you’re less likely to experience as large a loss with DOG than with some of the other ETFs (especially the leveraged ones).
You don’t need to read a finance book to know that you should only invest in inverse ETFs if you know what you’re doing. Inverse ETFs are a high-risk way to bet against the market. Needless to say, they also have the potential to produce tremendous returns. It isn’t an accident that most millionaire and billionaire hedge fund managers have dabbled with short ETFs.
If you DO decide to include some short ETFs in your portfolio, some of the best ETFs that short the market are:
- ProShares UltraShort S&P 500 (SDS)
- Direxion Daily S&P 500 Bear 3X Shares (SPXS)
- ProShares Short Russell 2000 (RWM)
- AdvisorShares Ranger Equity Bear ETF (HDGE)
- ProShares Short Dow30 (DOG)
If you do your due diligence and size/time your investments correctly, who knows… maybe one of these ETFs could make you a lot of money and build you a lot of wealth… 🙂