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August 26th, 2011 by

Short but not short changed

Short but not short changed – inverse ETFs are good tools in our investment toolbox

At some point my mother or my father told me not to play with fire, appropriately so, and I most certainly intend to pass on this sage advice to my son. I think a similar advice is floating from lots of financial sources regarding shorting in general and regarding usage of the inverse ETFs in specific: the inverse ETFs are bad, they are dangerous, stay away unless you know what you are doing, otherwise you will get hurt. According to Barron’s, some pundits even call them “investment porn”.

I say, why so much misguided wisdom goes toward such versatile investment vehicles? Or better yet, how come I would even dare to question such advice.

On the face of it I agree with most criticism regarding shorting in general and regarding the inverse ETFs in specific. The first and primary basic principal of shorting is that you can lose an infinite amount if you short a security and that is sound fundamental financial fact. If you short something as the price goes up, you are liable to lose however much the stock goes up, in theory, to infinity.

True for stocks, but not true for inverse ETFs. When you buy an inverse ETF, let’s say “SH”, which is the inverse of the S&P 500 Index, or more appropriately the inverse of the “SPY”, which replicates the S&P 500 index, for every dollar that SPY goes up the SH goes down. But the most that you can lose is actually the amount that you bought SH for, similarly as if for any long investment. So the first point of infinite loss does not apply to the inverse ETFs.

The second point that is mentioned often is that most inverse ETFs do not exactly replicate the inverse price movement of their underlying benchmark, which is also true. This is especially true for leveraged ETFs, and that is because the managers who manage these vehicles do not short the underlying stocks, but use derivatives to replicate the inverse performance of the benchmark. This also brings out another negative point is that the volatility (i.e. risk) of the inverse ETF is higher than the equivalent long ETF, which is also true.

Financially correct, but practically not relevant, since most ETF users are not day traders. We would use these inverse ETFs ether for hedging or if we want to implement our view that the market is going down. So if the inverse ETF does not exactly replicate the inverse of the index the impact on the hedge is trivial. If you believe that the market is going down and you want to take advantage of it, once again, the lack of precise inverse replication is not relevant because our view is that the market will drop big and you are expecting to make money on the overall down trend.

So in a very practical example, some of my clients have IRA accounts. These accounts cannot be margin accounts and thus cannot short. But since one of my firm’s strategy is a Long/Short dollar neutral strategy I can still implement the short component in these IRA accounts by simply buying the “SH” when I need to short the market – like magic, and bypassing not having a margin account, I can short. It works great and highly effective.

One caveat in this portfolio is that I can only use 50% of the portfolio on each side. In other words if I have a $100 portfolio, I would buy $50 worth of long positions and $50 of “SH”, whereas if I had a regular margin (non IRA) account I would buy $100 of long positions and $100 of short “SPY” position, thus doubling the effectiveness of the portfolio. Financially speaking, the net leverage of both portfolios is zero, whereas the gross leverage in the IRA account is one (i.e. no leverage) and the gross leverage of the margin account is two (or double leverage). This works and works very well.

Now here is a crazy idea that someone should focus on, how about shorting “SH”?

Position disclaimer: I and client portfolios hold SPY, SH

 

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