ETFs That Let You Short Sell

The strategy of short selling -- betting on a stock's decline -- has been inching its way into the investing mainstream, despite being difficult to do and highly risky.

In fact, mutual funds that use market-neutral, long-short and other strategies that involve, at least to some degree, going against stocks have proliferated in the past few years. All employ short-selling techniques that previously had been available only to high-end investors through hedge funds and sophisticated financial advisers.

If you're managing your own portfolio, though, selling a stock short is still a pretty big leap. To do it, you must borrow shares of the stock from a broker, sell them, then replace the borrowed shares later when their price is (hopefully) lower.

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However, if you bet on a $30 stock to fall and it rises instead to $80, you lose $50 per share. Moreover, your potential losses are unlimited. That's why most brokers don't go out of their way to encourage short selling or to make it easy to do.

Now investors who want to create their own hedges or speculate that a sector is ready to tank have a relatively safe and tempting alternative with a new series of exchange-traded funds from ProShares.

First introduced in 2006, these so-called short ETFs produce inverse returns. That is, if the index loses $1, the short fund produces a gain of $1. (Keep in mind that it works both ways: If the index gains, the short fund loses.)

ProShares also offers leveraged short funds that give you a gain equal to twice an index's loss as well as leveraged "long" ETFs that give you double an index's gain. The leverage is created by a bit of financial engineering that employs futures and swaps as well as shares of the underlying security, says William Seale, chief investment officer for Bethesda, Md.,-based ProShares.

ProShares sister company, ProFunds, and a rival, Rydex, have long offered traditional mutual funds that do the same thing. But it appears that ProShares' ETFs, with lower expenses (0.95% annually, vs. 1.22% to 2.95% for ProFunds mutual funds) and the ability to trade in and out throughout the day, are eclipsing them. In just 16 months, ProShares ETFs have gathered $9 billion in assets, outstripping the nine-year-old ProFunds' $8 billion in mutual fund assets.

About 80% of ProShares' ETF assets are on the short side, says the firm's chief executive, Michael Sapir. That should come as no surprise. They are the only short ETFs on the U.S. market.

In October, ProShares began rolling out a series of six long and short ETFs that track foreign developed and emerging markets indexes to complement its lineup of 52 ETFs that track U.S. stock indexes. More short and long ETFs are coming, perhaps including some that track the bond and commodities markets. Sapir says he can't yet be specific about what's in the works.

There are, of course, other ways to profit from a stock's fall, including buying put options and futures. But puts have a limited lifespan. They can become worthless at expiration if a stock or index doesn't make the move you expected. Futures are marked to market daily, which means losses are deducted from your account (and gains are added) even if you don't sell the position. And because futures are highly leveraged (that is, you pay for just a small percentage of your purchase in cash up front), a small adverse move could mean a big hit to your portfolio.

Short funds and ETFs are easier to understand because they work much like a mutual fund. Importantly, any losses are limited to the amount you invest (plus commissions). Investors should use caution with the leveraged versions, however, because they can magnify losses as well as gains.

How can investors use short ETFs in their portfolios? Here are a couple of examples: Perhaps you think the Chinese stock market, which is up an astounding 250% in the past year, is due for a fall. You can speculate that it will by buying the Ultrashort FTSE/Xinhua China 25 ETF (symbol FXP), which will launch later this month.

Or perhaps you own shares of Apple and Google and feel confident about both stocks, but you want to protect yourself against a possible downdraft in the technology sector. Shares of the Ultrashort Technology Index (REW) will do the trick.

Keep in mind that ProShares' leveraged funds and ETFs are designed to produce twice the daily return, positive or negative, of the underlying indexes. Over time, though, returns won't exactly equal twice an index's return or twice the inverse return.

There is a compounding factor that over a long upswing in the underlying index could produce gains of more than 200%. On the down side, the compounding factor works in reverse and serves to slightly moderate an index's losses.

Although the ProShares ETFs are relatively straightforward, shorting is a much different game from picking stocks you think will go up. Most of ProShares' customers on the mutual fund side are financial advisers and other professionals. If you're not a pro, tread with caution. The stock market tends to rise over the long run. Going short generally works only over short periods of time, and timing is everything.