Short ETFs: Like honey for bears, but don't get stung
If you're an investor, you've been seeing some scary headlines:
- 'Hindenburg Omen' looms over Wall Street
- Beware: Market valuation looks like 2007 again
- Cramer: 'Giant reset' looming for markets
- Stars aligned for a 'serious' US correction
And those are just from this week. Of course, there are bulls who take the other side (see Wharton professor Jeremy Siegel's assurance from the week before, Keep buying—you 'can't lose,' or the estimation Thursday by Wells Fargo Private Bank CIO John Lynch that the S&P could trade at 1,900 'relatively easily').
But if you think the Dow's 15 percent rise this year (down from 19 percent a couple of weeks ago) is unsustainable and that a pullback is inevitable, or you're sure that Fed tapering is nigh and is going to send investors into hiding, bears can find ways to bet on a bust.
One is the short exchange-traded fund, aka inverse ETF, and one industry source said there's been a noticeable uptick in inflows into such instruments in the past few weeks as more people raise alarms about the market. Alternative ETF provider ProShares said it has seen net inflows of $3.8 billion into inverse products in 2013, although more than half of that was in the first three months.
Just as when you short a stock, with short ETFs you're expecting to make money from the decline of securities' value. And with leveraged short ETFs—2x and 3x funds—it's possible to dramatically escalate returns. As you might expect, the same is true of losses if the market doesn't go your way.
Richard Saperstein of Treasury Partners said that such turbocharging means the funds must be reset daily, and there's an embedded cost in such frequent rebalancing.
He doesn't use short ETFs. When feeling defensive, he said, "we prefer buying protective puts," referring to the insurance-like strategy to safeguard unrealized gains.
(Read more: How to protect your portfolio for free)
Jeff Powell, managing partner at Polaris Wealth Advisers, said he was more concerned that short ETFs don't mirror the market with much precision.
"My biggest issue with them is the tracking errors"—the divergence between the price behavior of the short ETF and that of the benchmark index, he said.
Tracking errors average 20 percent on the 1x funds, to 42 percent on 3x funds on an annual basis. By comparison, the SPDR S&P 500 ETF Trust has a tracking error of just 0.3 percent.
Others say that just as investors set a tolerance for portfolio imbalance, so they set their tolerance for tracking error.
Powell conceded that the issue may not be such a big deal for someone getting in and out in a matter of weeks. "But you better have it right and at the right time."
He doesn't believe in predicting the market—and he apparently doesn't believe much in shorting: Of Polaris' $400 million under management, $350 million is in ETFs, but zero is short.
Part of the appeal of short ETFs is their ease of access. Anyone can trade them, while shorting a stock requires a margin account. In a sense, they replicate the performance of using margin without all the costs (although short ETF fees are higher than those for traditional ETFs.)
They're also popular as a means of risk management, to protect assets in a declining market.
Or take someone who wants to protect fixed income and sees rising interest rates approaching. That investor might want to put money into an inverse Treasury ETF such as ProShares UltraShort Barclays 20-Year Treasury ETF, the largest short ETF, with a market cap of $4.09 billion.
(Read more: What is fair value for the 10-year Treasury?)
Still, Saperstein said, he'd had better luck with shorting zero-coupon Treasury bonds.
Powell said that even if someone feels certain that Fed Chairman Ben Bernanke will start tapering the central bank's $85 billion monthly stimulus in September—no one knows what that means.
"He's never put a dollar figure on it," he said. "Does it mean going from $85 [billion] to $84? Or $85 to zero?"
(Read more: Will US yield spike derail tapering plans?)
Though Powell allowed that a 10 percent market pullback is "certainly possible," Polaris is, for now, "moderately bullish." But, he added, "predicting markets and movements is more about making a name for yourself than doing what's best for your clients."
Some of the more popular short ETFs are ProShares UltraShort S&P 500 ETF, Direxion Daily Small Cap Bear 3X Shares, Direxion Daily Financial Bear 3X Shares and Direxion Daily 20-Year Treasury Bear 3X Shares ETF.
—By CNBC's Matt Twomey. Follow him on Twitter @Matt_Twomey.