The easy way to bet on a Chinese stock market disaster

Fourteen of the top 15 exchange-traded funds in 2015 were negative bets: short commodities or Brazil, a major oil producer itself.

And that's no surprise, as inverse ETFs — those that use derivatives to make short bets of up to three times the underlying market risk— will produce outsize gains if the bets are well-timed.

The only top-performing ETF in 2015 that wasn't an inverse bet: the small-cap Market Vectors China AMC SME-ChiNext ETF (CNXT), which returned almost 51 percent.

On the first day of trading in 2016 — with China's stock market in free fall — investors may be interested in putting those two top-performing ETF ideas together, and start the new year by taking a look at ETFs that bet short against the Chinese stock market.

A man looks at an electronic board showing stock information at a brokerage house in Beijing, China, January 4, 2016.
Kim Kyung-Hoon | Reuters
A man looks at an electronic board showing stock information at a brokerage house in Beijing, China, January 4, 2016.

Last June, Direxion Investments — known for its family of inverse and leveraged ETFs — launched the Daily CSI 300 China A Share Bear 1x Shares (CHAD). Some investors took note: the ETF has raised $165 million since June, which would rank it among the top 10 most popular new ETFs, ranked by assets, in 2015.

Tom Lydon, ETFtrends.com editor and Global Trends Investments president, said CHAD, "totally nailed the timing."

"Timing could not have been better. The inverse or bearish China ETF was the only one on the market that shorted the China A-shares market," Lydon said. The ETF expert was referring to the late-summer swoon in Chinese stocks, but with the underlying China stock index down 9 percent on Monday, shorting China through an ETF was a trendy 2015 investment that may be built to last.

Todd Rosenbluth, director of ETF and mutual fund research at S&P Capital IQ, provided three reasons to be wary of using an ETF to short China.

1. These ETFs aren't cheap.

2. They don't trade with the most efficiency. The bid/ask spread on CHAD is 8 cents, which might seem low but is relatively high for an ETF.

3. They aren't very liquid. CHAD trades 90,000 shares on a daily basis.

Stlil, Neena Mishra, director of ETF research at Zacks Investment Research, said that CHAD's expense ratio of 0.80 percent is reasonable compared to other leveraged/inverse international ETFs.

"Worries over the Chinese economic slowdown dominated financial markets last year and the world's second-largest economy still remains a wild card in 2016," Misra said.

Chinese policymakers have been trying to change the growth model from manufacturing to services, from investment to consumption, and from exports to domestic spending. "This transition to the 'new normal' is proving to be quite painful," Misra said.

Such transitions are almost never smooth; more so in the case of larger economies. But Misra said making matters worse, "the Chinese government clearly lacks crisis management skills. ... This year as well, we are likely to see severe bouts of turbulence in the Chinese stock market with reverberations around the world."

Jon Najarian, CNBC "Fast Money" trader, wrote on Monday: "China has fallen before, China has rallied before. We've seen swings of 10 percent up and down from China, and we're still here. They have banned short selling in the past — and they will do it again. They have cut and raised interest rates — and they will do it again. They have bought back shares and applied quantitative easing (QE) methods to the problem — and they will do it again. China will continue to be volatile."

If the "short China" is trade built to last — at least well into 2016 — it's only built to last for one day at a time, making it tricky for investors to play.

So Misra said that while an ETF like CHAD could be used to bet against the largest and most liquid stocks in the Chinese A-share market, timing the country's market is not going to be easy and an ETF would be best used to hedge an existing portfolio position. China's stock market has become a position in which more long-term investors now have at least some exposure.

"It would be a perfect hedge for investors long the same China A-share market," Misra said.

CHAD's underlying index, the CSI 300 Index (ASHR), fell almost 9 percent Monday and CHAD rose about 9 percent, "so it would be a perfect hedge against ASHR."

Misra said it could also be used for hedging exposures to other Chinese stocks, just not by the same magnitude.

There's a consideration, though, with any inverse ETFs, that makes them dangerous to hold as anything other than a short-term bet against a market. These fund are typically rebalanced daily (CHAD included) so investors should remember that it can underperform its stated objective if held for longer than a day.

The managers of inverse ETFs use a variety of strategies, including derivatives and shorting stocks, to meet their objectives. If the underlying stocks fall, these inverse ETFs will appreciate and the next day, the managers would have to sell more stocks at lower prices. On the other hand, if underlying stocks go up, inverse ETFs will have to reduce their short exposure by maybe buying stocks at higher prices. This could lead to underperformance.

The Securities and Exchange Commission provides some real-life examples of how extreme this underperformance can be. (The agency recently undertook a new proposed rule-making to limit inverse and leveraged ETFs.)

Misra said as long as investors understand this quirk, CHAD and other inverse China ETFs could still be viable hedging options for short-term periods like a few days, even though they would provide less than a perfect hedge.

There's a more fundamental concern some ETF experts have — investors attempting to time the market at all.

"If China and emerging markets bounce back, so will China ETFs or even funds that track the oil sector. So small investors are usually best off picking ETFs that check important boxes in their asset-alllocation plans and watching out for fees," said Ben Johnson, Morningstar's global director of ETF research.

— Additional reporting by Timothy Mullaney and Joe D'Allegro, special to CNBC.com