Using 'Short' ETFs to Prepare for Correction

The Dow Jones Industrial Average may have crossed 10,000, but the Nasdaq Composite has remained stubbornly below my next selling threshold, which is about 2200. While waiting for this milestone, which would mark a 75% gain for the Nasdaq since its March low, I’ve had plenty of time to explore options for reducing my exposure to the stock market. That has led me into new investment territory, at least for a relatively cautious investor like me.

At previous selling thresholds, I’ve taken profits and reduced my exposure either by selling individual stocks, selling covered calls on stocks, or selling index or mutual funds. But this next selling threshold (assuming we actually reach it) isn’t like most others. It would represent the third consecutive 25% rise in the Nasdaq without an intervening correction. (The Common Sense system calls for buying on 10% drops in the Nasdaq, and selling on 25% gains.)

A year ago, as we were experiencing repeated buying opportunities without any intervening rally, I observed that our conviction about buying should increase the longer the trend persists, since the odds of a rebound grow ever larger the further from historical norms the market averages get. Human nature being what it is, conviction didn’t deepen. On the contrary, what increased for most people was the fear of further losses and an aversion to putting more money into the market. Now those emotions are working in reverse. No one wants to be the first to leave the party.

This is just as irrational, if emotionally satisfying. I never predict the near-term direction of the market, and we may well be heading to new highs. But strictly from a historical perspective, this market is overdue for a correction.

As a result, I found myself examining the many offerings in the ProShares family of exchange-traded funds that let investors profit from market declines. I find I’m avoiding the phrase “bet on market declines,” but let’s face it, that’s pretty close to what this is. Still, I came away convinced that in unusual circumstances, some of these funds can play a useful role in even a conservative portfolio.

These short ETFs essentially offer a hedging tool and a way to profit from declines without having to sell anything short or wade into the options markets, the more traditional ways to profit from a market going south. As I’ve said before, I never short stocks or indexes because such investments carry the risk of unlimited loss. The ProShares ETFs I’m concerned with here don’t sell short, either. They use derivatives, such as swaps (where two parties to the transaction agree to exchange the returns on agreed-upon underlying investments), to carry out the funds’ various strategies. They may also add leverage to magnify gains (and losses). While options have fixed expiration dates, the ETFs offer the flexibility of selling whenever an investor chooses.

The ProShares short funds are designed to be the exact inverse of the relevant index; the leveraged ultra short funds aim to be twice the inverse and there are even some that target three times the inverse. For example, if the S&P 500 dropped 10%, the ProShares Short S&P500 (SH) would hope to gain 10% and the UltraShort S&P500 (SDS) fund would expect to rise 20%. Losses, of course, are also magnified by leverage. But you can’t lose more than 100% of your investment.

ProShares warns investors that it aims to have the funds’ movements correspond to the inverse of the relevant market indicator on a daily basis. Over more than a day, the effects of compounding can (and generally will) dilute or enhance those results. If someone invests $1000 in the Short S&P500, and the index loses 1% in a day, the investor would expect to have roughly $1010. If the index loses another 1% the next day, the investor would anticipate $1020.10. This adds up over time, as the funds’ results show. For the second quarter of 2009, when the S&P 500 gained 15.93%, the Short S&P500 lost 16.03%, a pretty close inverse correlation. But over longer periods, the results can be much less predictable, especially during periods of high volatility. Year-to-date the total return for the S&P 500 is up 20.10%, but the short fund is down 22.63%. And of course, these short funds have lost value during this year’s long-running bull market. The Short S&P 500 shares hit $93.14 during the past year; this week they were at $55 and change.

In any event, no one should expect these funds to achieve a precise inverse correlation to the underlying index. Nor should these ETFs be long-term holdings. Given that the historic market trend is up, and that bear markets on average are much shorter than bull markets, they should be used only for short-term hedging strategies. The problems of compounding and volatility can grow more acute the longer one of these funds is held. As a result, they should be monitored closely. I can’t see owning one of these for much longer than three months.

Indeed, except in extraordinary circumstances, I can’t see owning one of these at all. But as the Nasdaq flirted with 2200 last week, I decided to see if now is one of those times. I bought a modest position in the UltraShort S&P500 ETF as an experiment. I’m deliberately calling this an experiment, not a recommendation. I suggest that conservative investors let me be the guinea pig. I’ll keep you posted as my experiment progresses.