When the SEC temporarily banned short selling on Sept. 18, investors lost an important tool for coping with the bear market. But the ban did not affect another source of recent profits: inverse mutual funds and exchange-traded funds, which rise when the market falls.
Even after the ban ends, investors will have good reason to use the funds instead of shorting stocks directly. "Inverse funds can be very cost-effective ways to hedge," says Michael Sapir, CEO of ProShares Advisors, which manages ETFs.
The funds achieve gains in downturns by trading futures and options. Because they do not sell stocks short, the SEC ban did not apply to the funds. During the first weeks of the ban, trading volume of the funds spiked as investors sought bear-market choices that were still available. Unable to short financial stocks, investors bought ProShares Short Financials (SEF), which advances when there is a decline in the Dow Jones U.S. Financials Index.
ProShares and Rydex Investments are the leading managers of inverse funds, offering a range of choices that enable investors to short an index, such as the Russell 2000, or a sector, like energy. Consider Rydex Inverse S&P 500 (RYURX), a mutual fund that delivers the inverse of the S&P. If the S&P drops 1% on one day, the fund will rise 1%. Because of expenses and the effects of compounding, the funds don't provide an exact inverse of benchmarks over long periods. But the results have been close to what investors expect. During the first eight months of 2008, the Rydex S&P fund returned 12.6%, while the S&P 500 lost 11.4%, according to Morningstar.