Short ETFs Can Hedge Portfolios When Markets Sour

Next week promises to be another tough one for investors. The Federal Reserve gathers for a highly anticipated meeting on interest rates. And several prominent companies report their latest financial numbers, ringing in the beginning of another earnings season. If the Fed doesn't cut between 50 and 75 basis points, or if some big-name companies announce troubling earnings, then investors could find themselves dealing with a raucous stock market.

Most long-term investors chalk up these wild rides to the normal machinations of a business cycle. However, a growing number aren't content to sit back and watch their account balances shrink. Those investors are lining up alongside large institutions and hedge funds to make calculated bets about the direction of the market. By using so-called "leveraged" or "short" exchange-traded funds, these investors are trying to make money when everybody else is losing it. The tactic has become one of the most prominent trends so far this year. ProShares, a leading sponsor of short and leveraged ETFs, has seen over $4 billion flow into its offerings this year, one of the largest tallies of any firm in the industry.

The concepts behind short and leveraged ETFs are quite simple. By employing a mix of futures contracts based on a given benchmark, say the S&P 500, a short ETF will try to show a profit when that index is tanking. ProShares and Rydex also have a lineup of funds that take the idea a step further. These ETFs — ProShares calls them "ultra" ETFs; Rydex denotes them with a "2X" label — try to produce twice the returns of the S&P 500 during a rally (leveraged) or twice the inverse returns (short) of that same index during a bear market.

Some investors have been incorporating these ETFs into their portfolios to take advantage of the recent market conditions. We don't advocate such a short-term strategy, even if it has proven itself to be profitable. Indeed, the ProShares UltraShort S&P 500 (SDS) ETF has returned 22% this year. However, investors are also employing these funds as a powerful hedging tool for other positions in their accounts. This can be a smart strategy that can help offset risk, keep taxes to a minimum and, most importantly, protect principal.

In the past, orchestrating a hedge based on shorting the market was a potentially perilous procedure. You would borrow shares that cost, say, $10 a piece, and hope that they would decrease in value to around $5 each. That way you could return the shares to the original owner and pocket the $5 difference. The problem: If the shares went up your potential losses were virtually endless. ETFs alleviate some of that risk because investors don't have to borrow shares to short the market. And they potentially won't lose as much in value as an individual stock when a trade turns sour.

"It's hard for me to imagine one of these ETFs going to zero," says J.D. Steinhilber, founder of Agile Investing in Nashville.

Advisors are using ETFs to perform several hedging tactics. Let's say you are fed up with paying $3 or more a gallon to fill your car up with gas. You could purchase an oil ETF like MacroShares Oil Up (UCR) that rises in value as the per-barrel price of crude increases. This ETF has returned 55% the last year as black gold has hit a record $111 per barrel. Advisors also use ETFs as a tax hedge. In some cases, advisors are forced to sell positions in order to generate losses in clients' accounts that would help offset potential capital gains. Despite selling, they may still feel strongly about the potential profits of that position or the industry it's in. So, the advisor will buy an ETF that tracks the industry. It serves as a placeholder until the advisor has recorded the loss and eventually rebuilds the position.

Now, leveraged and short ETFs are allowing advisors to pull off more complex strategies. For example, tech had a decent year in 2007 and many investors started putting money back into this sector after years of staying away. However, the recent turmoil has technology and telecommunications mutual funds down 16% and 20%, respectively, according to Lipper. The prospects for tech are still decent — if you have the patience to wait out the bad times. If you have $10,000 in a tech fund, you could hedge maybe 20% or 30% of that position by shorting the Nasdaq Composite, a very tech-heavy index. The ProShares Short QQQ (PSQ), which tries to post the inverse returns of the largest 100 nonfinancial stocks on the Nasdaq, has returned 18.8% year to date. You'll still be in the red overall, but you'll have stemmed some of the bleeding. (Advisors will increase that percentage depending on what they're hedging and a client's risk tolerance.)

It gets tricky when investors start dabbling with the ultra and 2X ETFs. These funds have become favorites of sophisticated investors making very short-term plays on the market. Indeed, the average investor sticks with a ProShares fund for three days before selling. Those investors probably have a small army of analysts who've done their homework. Most armchair investors don't have time to calculate whether the market will rise or fall depending on certain conditions. Indeed, most of the advisors we talked to for this story thought the smarter approach was to create a well-diversified portfolio whose asset allocation shifted with the market's whims. Investors may not enjoy a short-term pop, but over the long term this strategy will accomplish basically the same thing — and with much less risk.

"[These ETFs] aren't for your typical person trying to save for retirement," says Steve Hammers, chief investment officer of Compass Efficient Model Portfolios, a Brentwood, Tenn., investment firm specializing in ETFs.