Exchange-traded funds (ETFs) are baskets of securities that have a few more perks than traditional mutual funds. They can be traded throughout the day on the open market, much like stocks, and they can be sold short. When you sell short, you're betting against a rise in the market. Most people choose to short ETFs as a way to protect their portfolios. The investment also has some additional attractive benefits. However, short-selling ETFs also has its disadvantages, and for those investors who want to skip those downsides, a comforting alternative is available.

Tutorial: ETF Investing

How ETFs Are Shorted
Shorting this investment requires that you borrow a number of shares of stock or an ETF - from a brokerage firm - that you want to sell. The process typically takes place within a margin account. This is an account in which the firm lends you money to purchase the securities. The broker may borrow the securities from another client or from another firm, and the ETF is sold on the market. During this time, the seller is charged interest on the loan and will need to pay any dividends to the lender. The hope is that the market will fall. The decline will cause the price to drop, allowing for the securities to be repurchased at a lower price, the proceeds deposited into the account for the loan to be repaid and a profit to occur from the difference in the amount for which it was sold versus the amount for which it was repurchased.

Reasons ETFs Are Shorted
ETFs have several features that make them attractive for selling short. They are an aggregation of thousands of companies, which means they contain dozens of stocks, as opposed to a single stock. They are also designed to track the index. Some ETFs follow the U.S. stock in its entirety, foreign markets and individual industries. Varieties of ETFs exist and are categorized by an investment theme.

They can be bought through a brokerage firm or acquired online. ETFs are bought and sold throughout the day on the stock exchange. They are diverse and therefore exempt from the uptick rule. This is a rule the U.S.Security Exchange Commission put into place to oversee short selling. It states the price of the security must have first risen from the last sale before it can be shorted. Short selling ETFs is often a means to offset or reduce risk within a portfolio. (For more ideas on how these funds can reduce your exposure to market risk or enhance portfolio performance, read Inverse ETFs Can Lift A Falling Portfolio.)

Who Shorts ETFs?
Sophisticated traders, hedge fund managers and other professional money managers short ETFs, as well as conservative and aggressive investors.

Advantages of Shorting ETFs
Shorting ETFs has several advantages. For one, they have more trading flexibility. Generally, they are highly tax efficient compared to mutual funds, because they defer capital tax gains. Buying ETFs is also less risky than buying the individual shares, since less money is lost. They also are not affected by short squeezes. Short squeezes occur when the price of the stock starts on a quick rise when the supply is lacking. Traders with short positions try to buy stocks to prevent losses, which only spikes the prices even further, making the losses of those who shorted and didn't close their positions even worse. ETFs don't suffer from this because of the number of shares that can be increased on any trading day. (Learn the differences between these investment products and how to take full advantage in Mutual Fund Or ETF: Which Is Right For You? and Capitalizing On ETF Tax Rules.)

Disadvantages of Shorting ETFs
Shorting ETFs isn't always the best move. The process can be difficult to execute, and can lead to even greater risks if the move is not timed right, however, they are easy to trade and can lead to poor decisions from those who aren't savvy. It can also be hard to determine who's placing bets with an ETF. ETFs have the potential to be exposed to unlimited loses. Not all ETFs can be shorted, and some are hard to short, as it is difficult to do so in small quantities.

An Alternative: Inverse ETFs
Some people have gravitated to inverse ETFs, which are also known as short ETFs. They are designed to go up when a particular sector or index declines. These ETFs provide all the benefits of short selling, but don't require that you make a direct short sale. This means a margin account is not required, so certain fees and costs are avoided. Inverse ETFs can allow you to profit from the market and can help hedge exposure to downside risk in your portfolio. However, they aren't good for rising markets, need skillful market timing and their performance history is limited because they are relatively new. (If volatility and emotion are removed, passive, long-term investing comes out on top, see Buy-And-Hold Investing Vs. Market Timing and Understanding Cycles - The Key To Market Timing.)

Short selling ETFs can be done. In fact, they can be shorted much like stocks. ETFs offer the additional benefit of having a batch of securities which makes them more diverse and less risky. However, selling short is not advised for the inexperienced.

Before shorting, first determine whether it's a good idea for you to invest in ETFs. According to Vanguard, people who should consider the investment are:

  • long-term buy-and-hold investors
  • investors with a sizable lump-sum amount to invest
  • investors looking for the trading flexibility of stocks

People who should not consider ETFs are:

  • Investors who rebalance frequently
  • Investors engaging in regular transactions
  • Investors with a small amount to invest

With ETFs, shorting is a strategy that many investors have access to, but it's not without its risks. Make sure you have all of the information and experience needed to make it an profitable play.