When markets turn down, the hated short sellers appear. The volume of short sales — bets that stocks will drop — spiked after technology shares began collapsing in 2000. Not surprisingly, short volume has climbed again in recent months. But in the latest downturn there has been a new twist: Much of the short selling has involved exchange-traded funds. The increasing variety of ETFs has made it possible to short in ways that could not be done when the Internet bubble burst. Given their run over the last few years, ETFs of emerging markets and China have witnessed some of the heaviest activity.

Investors short ETFs for the same reasons they use them to go long: low expense ratios and convenient trading. Advisors who want to protect client nest eggs can short popular funds, such as PowerShares Short QQQ (PSQ), which tracks the NASDAQ 100, and SPDR S&P 500 (SPY). In recent months, advisors have also been embracing inverse ETFs, funds that move in the opposite direction of market benchmarks.

ACROSS THE INVERSE

With more than 600 ETFs available, advisors can employ a wide range of hedges. Say an investor wants to hold a long-term position in the emerging markets, but fears that the bubble is about to pop in China and Brazil. The nervous investor could buy iShares MSCI Emerging Markets (EEM), and sell short ETFs that track the individual countries, iShares MSCI Brazil (EWZ) and iShares FTSE/Xinhua China 25 (FXI).

Suppose an employee of a bank holds stock in his company, and fears that the shares are about to plunge. Corporate rules may prevent the banker from shorting his company stock. But the nervous employee can short Financial Select Sector SPDR (XLF), an ETF that holds many banks. “ETFs make it possible to fine tune a portfolio and hedge out exposure to one country or a few stocks,” says Valerie Corradini, head of the private client group for Barclays Global Investors, the biggest manager of ETFs.

While the appeal of hedging is clear, many advisors cannot sell short for a variety of reasons. Firstly, short sales are forbidden by IRAs. And some brokerage firms bar shorting, arguing that it is risky; when the market moves against a short, the losses can be theoretically unlimited. In addition, shorting can be cumbersome: Clients must establish a margin account, and pay interest at rates of 8 percent or more. To avoid these problems, more advisors are turning to inverse ETFs. These can be held in IRAs, and there is no need to establish a margin account. With an inverse ETF, you can only lose 100 percent of your investment — not more. The leader in inverse ETFs is ProShares, which has 37 funds, including choices that enable investors to short the Dow Jones industrial average, the Russell 1000 growth index and a number of sectors, such as basic materials and consumer goods. The other major player is Rydex Investments, which has three inverse ETFs.

The inverse ETFs are appropriate for conservative or aggressive clients, says Dean Aita, managing director of Ericson Financial Services, a registered investment advisor in Washington Depot, Conn., that clears trades through Royal Alliance Associates. “Some of our conservative, older clients have been especially pleased to see that their savings were protected in downturns,“ says Aita.

Aita has been using inverse Rydex ETFs. He varies the hedge depending on the volatility of a client's portfolio. For a conservative portfolio that has half of the assets in stocks, and a big stake in fixed income, he might put 5 percent of assets into a hedge. If the client is more aggressive and has 80 percent of assets in equities, Aita would put up to 20 percent of the portfolio into the hedge.

DOUBLE BETA

Most of the short ETFs deliver the exact inverse of a benchmark: If the S&P 500 drops 1 percent one day, the ETF rises 1 percent. Some of the ETFs use leverage. When the S&P falls by 1 percent, Rydex Inverse 2x S&P 500 (RYTPX) rises by 2 percent. The leveraged ETFs can provide more flexibility. Say an investor wants to completely hedge a $1 million portfolio that tracks the S&P 500. He could put $1 million into an inverse ETF. Or the investor could accomplish the same position by putting $500,000 into a leveraged fund — and invest the rest of his holdings into stocks or bonds.

The double-inverse funds provide more bang for the buck, says Kathy Boyle, president of Chapin Hill Advisors, a financial advisory firm in New York. Early in the year, Boyle put 5 percent of some portfolios into ProShares UltraShort MSCI Emerging Markets (EEV), a double inverse of the emerging markets, a position that proved profitable as markets around the world sank.

For more than a decade, companies such as Rydex have offered inverse mutual funds. Like the inverse ETFs, the mutual funds move in the opposite direction of benchmarks. But recently advisors who were using the mutual funds are switching to the ETFs. For starters, the ETFs are cheaper. The expense ratio on the Rydex Inverse 2x S&P 500 mutual fund is 1.69 percent, while the Rydex Inverse 2x S&P 500 ETF has an expense ratio of only 0.70 percent. More importantly, the ETFs provide faster trading. Like stocks, ETFs trade constantly during the day. In contrast, mutual funds are only priced at the market's 4 p.m. close. So if you buy a fund at 10 a.m., you will not know the price until late in the afternoon. “With ETFs, you can put in limit orders, and sell in the middle of the day if you need to,” says Kathy Boyle, president of Chapin Hill Advisors.

Boyle says that it is important to educate clients carefully about inverse ETFs. She starts by showing clients a chart of the Dow Jones industrial average from 1966 to 1982, a period when stocks bounced up and down and made little headway. She cautions that beginning in 2000, the markets may have again entered a flat era. “People who learned about investing in the 1990s aren't used to selling short,” she says. “But now clients need to understand that this is time when it may be smart to hedge.”

HEDGE YOUR BET

These ETFs move up when the market goes down.

Fund Ticker Expense ratio
ProShares Short QQQ PSQ 0.95%
ProShares Short Russell 2000 RWM 0.95
ProShares Short S&P 500 SH 0.95
Rydex Inverse 2x Russell 2000 RRZ 0.70
Rydex Inverse 2x S&P MidCap 400 RMS 0.70
Source: ProShares; Rydex