NEW YORK (TheStreet) -- A falling market doesn't have to mean a falling portfolio value. Hedge funds were designed to hedge, or have longs and shorts in order to be market neutral. Not everyone has the desire or the ability to short stocks but that doesn't necessarily relegate your portfolio to second-tier status.
I was recently asked how someone with a self-directed Individual Retirement Account can short the market. Futures make an ideal vehicle to profit from a declining market by short futures contracts, something even an IRA account is allowed to do. But he isn't set up for futures and doesn't know the first thing about them, much less effectively execute a winning strategy.
Wall Street created a solution for investors who want to hedge against or even profit during a falling market and it's called inverse/short/bear exchange-traded funds. I often refer to the SPDR S&P 500 ETF (SPY) - Get Report as a reference and usually trade oil through the United States Oil Fund (USO) - Get Report ETF. Both of these commonly traded ETFs allow investors to synthetically trade futures contracts in an equity account. In other words, ETFs trade on stock exchanges, but they're designed to mimic futures and or options on futures.
Inverse ETFs are the same in concept albeit instead of creating a long position they create the opposite or a short position. Best of all, they allow a short bias while capping risk to the cost of the ETF. When the market falls and other stocks are declining, inverse ETFs rise in value.
There is a significant downside to trading ETFs to which investors should pay particular attention and the cost of carrying it. ETFs and especially inverse or leveraged ETFs decay similar to options. The decay is generated from underlying transaction costs and management fees to operate any given ETF. Some, including the SPDR S&P 500, have relatively low costs, allowing for a buy and hold strategy. But others are more trading vehicles than investments.
The Direxion Daily Large Cap Bear 3X Shares (SPXS) - Get Report makes an effective vehicle to short the market on any given day, but don't hold it for weeks or longer. If you do, the decay akin to an option may lose value, even if the market drops.
Investors can dial-in exactly where they want to hedge and or create a short position. For example, one opposite (all major indexes have more than one ETF for long and short) of the Nasdaq 100 index PowerShares QQQ Trust, Series 1 (QQQ) - Get Report ETF is the ProShares Short QQQ (PSQ) - Get Report. An opposite of the before-mentioned SPDR S&P 500 ETF is the ProShares Short S&P500 (SH) - Get Report.
All of the mentioned ETFs have plenty of liquidity and allow for easy entry and exits with minimal slippage. When it comes to slippage and receiving favourable fills, not all ETFs are created equal. Some are thinly traded, and the spreads are highly destructive unless you're able to place limit orders allowing selling at the offer and buying at the bid.
It's also crucial not to simply jump in and to take your time to learn the nuances of any given ETF. Akin to most things in life, they each have their own rhythm and knowing what to expect ahead of time is mandatory.
I have a friend who previously helped design and create ETFs and one point he made abundantly clear to me to never expect a perfect X-to-one relationship between leveraged inverse ETFs and the underlying market. In other words, if an investor buys a Daily S&P 500 Bear triple-leveraged ETF and the market falls one point, don't expect the leveraged ETF to rise exactly three points.
The ETF may increase four points or it may only rise two or something in between. They don't operate in perfect synchronicity and market demand (or lack of) can skew the price from a perfect fit.
As with all investing, due diligence beforehand is much cheaper than learning on the job. That said, inverse ETFs allow portfolios of various types to protect and to profit from a falling market.
At the time of publication, Weinstein had no positions in securities mentioned.
This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.