By Christian Magoon
CEO, Magoon Capital
Historically October has been a poor month to be an investor in everything from stocks to gold. This year is no exception. October of 2012 is scaring investors away as broad-based U.S. stock indices and gold prices are in the red. Here's the October 2012 NASDAQ performance chart displaying ETFs representing the U.S. markets as well as gold bullion. The SPDR S&P 500 ETF (SPY), the SPDR Gold Trust (GLD), the PowerShares QQQ (QQQ) and the SPDR Dow Jones Industrial ETF (DIA) are highlighted.
However, there are ETFs designed to gain during periods of market declines like we have seen in October. A growing amount of short ETFs, and ETNs as well, allow investors to gain while the markets are in pain. Let's take a closer look at the 150 short exchange traded products (ETPs) in the marketplace that short everything from stocks to bonds to commodities. What exactly are short ETPs designed to accomplish? How can they be used in a portfolio to lessen market downturns? And what are some points to keep in mind when evaluating short ETPs?
Overview Of Short ETPs
Short ETPs allow investors to do something that seems a bit unnatural - go short by going long. Specifically investors can buy (or go long) an ETP which actually seeks to deliver the inverse return (so called "short" return) of a specific index over a specified period of time. The two primary variables pertaining to short ETPs are the period of time targeted by the ETP and the use of leverage by some short products.
Most short ETPs seek to deliver the inverse return of an index for a single day. Thus they are designed for a holding and monitoring period of one day or less. A smaller set of short ETPs are designed with a month as their target time period. As holding periods and returns can vary dramatically when it comes to short ETPs, it is important to match the product with the intended investment horizon. To confirm a short ETPs target time period, simply consult the investment objective in the ETP's prospectus.
Secondly short ETPs may seek to simply deliver the inverse return of the index or they may employ leverage to generate 2X or 3X the inverse return of the index. Leverage adds more volatility, also referred to as risk, to the investment. For most investors leverage is not appropriate but for those who understand and accept the elevated risk and reward factors, short ETPs are available in several leverage tiers. Most short ETPs indicated use of leverage and at what level in their official product name. Be sure to confirm this information within the ETP prospectus however.
Using Short ETPs
Short ETPs are used in a variety of different ways. Many active traders use leveraged short ETPs to magnify price movements in an index in order to increase reward potential. Of course this also increases the risk as well. On the investment side, short ETPs are often used to hedge the risk of a decline in a long position. For example, an investor may own the S&P 500 and is concerned about a decline in its value. One option to mitigate some of the risk of the S&P 500's decline is to buy a short S&P 500 ETF. Should the S&P 500 go down, the rise of the short ETP would help to offset that decline. Of course a leveraged short ETF could also be considered in that scenario as it would allow the investor to use less capital to obtain a larger opposing position. This would increase risk and reward.
Risks, Rewards & Key Data Points
As with all investment products, it is important to review a prospectus before investing to understand how the investment works and the particular risks involved. In addition, investors considering short ETPs should always pay attention to the index being tracked, the time targeted time period and the level of leverage if applicable. These three data points will dictate the returns and risks the ETP will be subject to.
Similar to reducing risks through the proper use of asset allocation in a portfolio, short ETPs can be part of an overall risk mitigation strategy when properly used. Investors who consider short ETPs should carefully read the prospectus to understand the unique risk and reward profile of short ETPs. Once understood and properly implemented, short ETPs offer opportunities for investors seeking to hedge, or even profit, from market declines.