A short exchange-traded fund (ETF) is designed to profit from a decline in the value of the underlying index. A short ETF gets its name from the fact that it is designed to benefit in the same manner as a short position in an underlying index. Thus, a short ETF will be profitable if the underlying index or asset declines in price, and will incur a loss if the underlying index or asset gains in price. Short ETFs can be used for speculation or hedging.

Short ETFs are widely known as “inverse ETFs”, and sometimes as “bear ETFs.” Short ETFs are not constructed through short positions in the constituents of an index, but rather, through the use of derivative instruments like options, futures and swaps.

Short ETFs have gained popularity because they are a viable alternative to short-selling, which has a number of drawbacks that make it onerous and risky to use for the average retail investor. Unlike a short sale, short ETFs do not require the use of a separate margin account. Short ETFs are also a cheaper way of obtaining bearish exposure than short-selling, which entails a number of expenses such as interest on the margin account, cost of borrowing the shorted security, as well as dividend payments made by the shorted security. Short ETFs may also be less exposed to other risks associated with short selling such as the risk of short squeezes and buy-ins, and regulatory risk.

Short ETFs are available on a wide range of indices and assets, and may also offer additional leverage. For example, the ProShares UltraShort S&P 500 S&P 500 Fund (SDS) seeks investment results that correspond to twice the inverse of the daily performance of the S&P 500. Thus, if the S&P 500 declines 2% on a given day, this UltraShort ETF should theoretically gain 4%. Conversely, if the S&P 500 advances 1.5% one day, the UltraShort ETF should theoretically decline 3%.

We say “theoretically” because short ETFs have very significant tracking differences compared to the underlying index. This tracking difference gets amplified over longer periods of time and with higher degrees of leverage. While this makes short ETFs suitable tools for hedging or speculating over short time periods such as days or weeks, they are much less efficient over longer time periods.

As an example of the effect of leverage on tracking difference, consider the following. The SPDR S&P 500 ETF (SPY) had a tracking difference of only 0.37% in relation to the underlying S&P 500 index as of July 2014; the ProShares Short S&P 500 ETF (SH) had a tracking difference of 18.2%, while the ProShares UltraShort S&P 500 S&P 500 Fund (SDS) had a tracking difference of 27.2%.

The Bottom Line

Short or inverse ETFs are a viable alternative to short-selling; while they can be a potent tool for speculation or hedging in the hands of experienced traders and investors, they should be used with caution by new investors.

Disclosure: The author did not own any of the securities mentioned in this article at the time of publication.

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