Don't Sell Yourself Short

At Morningstar, we do not recommend that the average investor engage in short-selling. Successfully betting on market downturns is very difficult, and even the most intrepid investors find it difficult to consistently execute an effective shorting strategy. Stock prices tend to rise over time, so shorting should be done only tactically and for a short period of time, if at all. As he often does, Warren Buffett gives some sage advice on the topic:

"It's an interesting item to study. It's ruined a lot of people. You can go broke doing it. Everything we've ever thought about shorting worked out eventually, but it's very painful. It's a whole lot easier to make money on the long side. You can't make big money shorting because the risk of big losses means you can't make big bets."

Despite these warnings, we still get questions about short-selling and the best way to go about it. In the interest of making our readers better-informed, this article will discuss the ways you can use ETFs to get short exposure and the pros and cons of each method.

Buy an Inverse ETF
The simplest and easiest way to get short exposure is to buy an inverse ETF. There are currently 244 leveraged and inverse products with $28.8 billion in assets. These products have been popular with investors because the ETF provider handles the complexities of managing the short exposure. Also, unlike other shorting methods, leveraged and inverse ETFs can be purchased in many tax-sheltered accounts. The upside to this downside exposure is that, when buying an inverse ETF, you cannot lose more than your initial investment. Conversely, shorting a security has theoretically unlimited potential losses. 

Most leveraged and inverse ETFs seek to match the daily return of the index by a prescribed amount. For example,  ProShares Short S&P 500 (SH) seeks to give investors negative 100% exposure to the daily return of the S&P 500. As my colleague Paul Justice detailed in his article "Warning: Leveraged and Inverse ETFs Kill Portfolios," holding these products for periods longer than a few days leads to very bad investor experiences. Because of the compounding arithmetic of constantly resetting the exposure to negative 100% of the daily return, investors are not guaranteed to get the index's inverse return for any holding period longer than one day. To counteract the effects of daily leverage reset, inverse ETFs need to be rebalanced regularly. For perfect tracking this needs to be done daily but could be done weekly to reduce trading costs. Managing an inverse ETF is definitely not a set it and forget it transaction.

Short an ETF
By short-selling an ETF like  SPDR S&P 500 (SPY), you get the opposite return of the ETF. If SPY goes down 10%, then your short position will be up 10% before fees. Shorting directly gives investors the return stream they intuitively expect instead of the volatility-dependent returns inverse and leveraged funds provide when held longer than their daily compounding period. Another benefit of shorting is that because fees lower returns, a short ETF position will benefit from the fees being charged inside the ETF. With SPY's ultralow fees of 0.09% this effect is minimal, but if you shorted higher-fee products, the ETF fees will provide a slight tailwind to your investment.

You need to open a margin account to short a security, but keep in mind that IRAs are not allowed to have margin. Once the account is set up, you'll need to borrow the ETF from someone else. Luckily, most ETFs are easy to borrow, and brokers typically maintain a list of easy-to-borrow securities on their website. If a security is not easy to borrow, your broker will often charge you a fee called the borrow rate. This fee is typically quoted as an annual percentage rate. Rates increase if the security is difficult to borrow. Another downside is that for ETFs that pay dividends, you are liable for the dividend payment to the person from whom you have borrowed the security. Your broker will typically just debit your account the amount of the dividend. 

Another downside is that because you are borrowing shares of someone else's ETF, they have the right to call them back. You may be forced to close your short position at an inopportune time. While this is unlikely to happen with liquid ETFs, it can happen with smaller funds that trade less frequently. The more likely scenario is that your broker will impose a borrow cost on you if the ETF you're shorting becomes more difficult to borrow. Finally, an ETF sold short has the potential for unlimited losses because it can theoretically rise to any amount.

Buy a Put Option on an ETF
Options on ETFs are very powerful tools that offer a multitude of investment strategies. Most option strategies require a fair amount of education and training before being deployed in a portfolio. One simple method to obtain short exposure is to buy a put contract at a strike price as close as possible to the current market price of the ETF. Simply, a put contract gives the buyer the right to sell an underlying ETF at a predetermined price within a specified time period. For example, if I buy one December SPY put option with a strike price of $135, I have the right to sell 100 shares of SPY at $135 anytime until the contract expires sometime in December. If from now until December SPY falls to $120, I can buy SPY for $120 and sell SPY for $135 giving me a $15 profit (minus the cost of the option). On the other hand, if the market rises in the next few months, the put option will expire worthless, and I will lose only my investment in the option. This is a 100% loss but I needed to commit only a small amount of capital to purchase the put option on SPY shares. The key advantage of using put options to short the market is that you know the worst-case scenario from the start. 

Put options require a margin account, and not all ETFs have options available. Because ETF option markets can have periods of illiquidity, investors should stick to the most actively traded markets. For example I would look to SPY instead of  Vanguard S&P 500 (VOO) for short exposure to the U.S. stock market. VOO is a great ETF with low fees but it has very limited option volume. To find current options prices and volumes, go to the Options tab on Morningstar.com's quote page.

Comparing the Options
The three different methods of obtaining short exposure all have their own pros and cons. One of the easiest ways to see the difference in their performance is to look at a real world example. Let's suppose that it's May 2011 and you're concerned that the simmering European debt crisis will sink the U.S. stock market. The following chart compares the three methods total returns from May 12, 2011, to Dec. 16, 2011. I use ProShares Inverse S&P 500 for inverse ETF exposure and SPDR S&P 500 for shorting and options exposure. The hypothetical does not include transaction fees.

  - source: Morningstar Analysts

  - source: Morningstar Analysts

Observations
Shorting SPY comes out the winner in this example by a substantial margin. Because SPY is one of the most actively traded ETFs, it is extremely easy to short and your broker is unlikely to charge a borrow cost. Notice that the inverse ETF tracks very well in the first few weeks, but it starts trailing as time goes by and volatility rises. SH's 0.90% expense ratio is also a small drag on returns. The put option trails because, in May 2011, many investors were concerned about the European situation getting worse. Heightened uncertainty results in higher implied volatility, which causes option prices to rise. Thus, the options were already fairly expensive when this model was first constructed. The initial cost was $8.34 for a 135 strike price put option. This initial premium adds an additional cost making it more difficult to for the put option to compete versus directly shorting. Because the put option cost only 6.2% of the value of SPY, the worst loss scenario is a 6.2% loss. In a scenario where the market rose substantially, the put option still would have been the best-performing method because it had the smallest loss.

When Should You Use Each Method?
Each strategy has a time when it can be used effectively. Buying an inverse ETF works best if you only want short exposure for a few days and you don't already have a margin account set up. Buying a put option is desirable if you want to cap you potential downside exposure at a reasonable amount. For all other scenarios shorting an ETF directly is the best option.

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Disclosure: Morningstar, Inc. licenses its indexes to institutions for the creation of ETFs and ETNs. Morningstar receives fees that are mainly based on fund assets under management. AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Scottrade, and Van Eck currently license Morningstar Indexes. These ETFs and ETNs are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on the Morningstar Indexes.