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Is it Time to Sell Short ETFs?

Is it Time to Sell Short ETFs?
By Ron DeLegge, Editor
March 5, 2009

SAN DIEGO (ETFguide.com) – Who would’ve thought major stock averages would be back to 1996-97 levels in 2009? I am displeased to report that’s exactly where we find ourselves today.

Major corporations like Citigroup (NYSE: C), General Electric (NYSE: GE), General Motors (NYSE: GM) and a host of other companies have failed their long-term shareholders. By decimating billions in market value, such companies have not acted out their role of being reliable “blue chip” stocks. At one time, many of these same companies were thought to be invincible. A dividend cut or a fall from grace was simply not possible. Even the money managers holding these stocks have been taken by surprise.

 

The main beneficiaries of today’s global recession (not depression, at least not yet) and subsequent stock market train wreck has been short sellers. Author Fred Scwhed Jr. called short sellers, “He of Black Heart.” Over the past 15 months, the “black hearts” have been in the green – in a big way. If you’ve been a short seller, let me offer my congratulations. Not only have you been in the minority, but you’ve been right. Now the next question becomes, will you continue being right?

The Strategy of Short ETFs
Some of today’s best performing exchange-traded funds (ETFs) are those with short and leveraged short strategies. These funds attempt to deliver the opposite performance of whatever stock, bond, or commodity benchmarks they’re tied to. For example, a short ETF tied to the S&P 500 tries to deliver the opposite or inverse performance of S&P 500 stocks. So, if the S&P 500 declines, a short ETF tied to that benchmark should theoretically rise. Conversely, if the S&P 500 rises, a short ETF tied to that index would decline.

There are two basic types of short ETFs – those that use leverage to magnify their market gains and those that don’t. ProShares, DirexionShares, and Rydex Investments each offer both leveraged and unleveraged versions of short ETFs. The leveraged short ETFs from ProShares and Rydex aim to deliver twice the opposite daily performance of their underlying benchmarks. In the case of Direxion’s leveraged short ETFs, they aim for triple magnification.

Let’s take a quick gander at some leading short ETFs.

ProShares Short Dow 30 (NYSEArca: DOG)
This ETF aims to deliver the opposite performance of the Dow Jones Industrial Average but without leverage. DOG has climbed 24.26% since the beginning of the year. Many stocks within the Dow like Bank of America (NYSE: BAC), Alcoa (NYSE: AA), and General Motors (NYSE: GM) continue to drag this blue chip benchmark through the mud. The annual expense ratio on DOG is 0.95% and the bid/ask trading cost spreads are just 0.02%.

Direxion Financial Bear 3X Shares (NYSEArca: FAZ)
If you really hate financial stocks, then you’ll probably love FAZ. This DirexionShares ETF attempts to deliver the triple reverse daily performance of stocks within the Russell 1000 Financial Services Index. The annual expense ratio is the same as SKF and the bid/ask spreads are a slightly more 0.06%. On a year-to-date basis, FAZ has climbed 124.06%.

ProShares UltraShort Financials (NYSEArca: SKF)
With S&P 500 financial stocks (NYSEArca: XLF) already down 45% year-to-date, SKF has jumped by 101.8%. SKF attempts to deliver the double reverse daily performance of financial stocks inside the Dow Jones U.S. Financials Index.

ProShares UltraShort MSCI EAFE (NYSEArca: EFU)
For a number of years, international stocks were outperforming U.S. stocks, but as of late this trend has reversed. EFU attempts to deliver twice the daily opposite performance of the MSCI EAFE index, a popular measure of international stocks in developed nations.  On a year-to-date basis, EFU has climbed 56.75% and in addition to annual expenses of 0.95%, the fund has bid/ask trading costs of 0.10%.

Watch out for Trading Costs
Since short ETFs are primarily designed as short-term investment vehicles, it’s important that traders and investors focus not just on expense ratios and the brokerage costs associated with buying/selling the funds, but another important component of cost: Bid/ask spreads.

The bid/ask spread is the difference between what buyers and sellers are willing to buy/sell their ETF shares at. Generally, ETFs with higher trading volume have tighter bid/ask spreads whereas ETFs with lower trading volume are the opposite. From a cost perspective, it’s advantageous to obviously use short ETFs with lower bid/ask spreads.

Exclusively focusing on annual expense ratios is a common mistake among short ETF investors. For example, the Rydex Inverse 2x S&P Select Sector Financial ETF (NYSEArca: RFN) has the same basic goal of SKF, but has higher trading costs. According to Morningstar, the bid/ask spreads on RFN are 0.57% compared to just 0.03% for SKF. Even though RFN has a lower annual expense ratio of 0.70% versus the 0.95% for SKF, the lower bid/ask spreads favor the latter. 

Conclusion
We know that stock investments fluctuate daily, but over long periods of time, we’ve been trained to believe they should increase in value. Over really long-periods of time, like 20 years or longer, stocks have shown a propensity to increase in value. Yet, over the past 13-years, stocks have gone up and then gone back down to where they started.

With swooning global stocks, short ETFs are recording impressive gains. However, because of volatility, those gains greatly fluctuate and in some instances evaporate very quickly. Short term trading trends may favor short sellers right now, but long-term history is not on their side.

Before you decide to jump on the short ETF bandwagon, it’s important for you to be realistic and educated. Did you even know that it’s possible to profit during a declining market without using short ETFs? In our March ETF Profit Strategy Newsletter, we just highlighted several alternative ETF strategies for profiting and hedging during a bear market.

 

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