If you're a regular reader of this column, you should know by now some of the advantages of exchange-traded portfolios over traditional mutual funds.
They're cheaper to own and easier to trade.
Now add another argument in favor of exchange-traded funds. They're easier to short. They are priced more frequently and therefore are easier to trade, and you can short them on a downtick. (I'll explain that shortly.)
Following the market's fantastic fluctuations last week, you may well be wondering how to make money on the downside.
Short-selling, or shorting, is certainly one way. If you short a single stock, you're betting that a single company will fall on hard times. It's a well-known, but dangerous, way to make money in a falling market.
"Clearly, you can have your head handed to you in a blink of an eye," says Jim Lowell, editor of the
However, you can also short some baskets of stocks, indices and mutual funds, which will let you bet on the decline of an entire sector or market index. It's still dangerous, but perhaps not as much as betting a single stock will fall.
In a short sale, an investor borrows securities (or shares of a fund) from a broker and sells them into the market with the understanding that the shares will be bought back at a later date and returned to the broker.
If the stock or fund declines in value, the investor buys it back at a cheaper price and makes money on the trade. If the stock goes up, the investor loses.
Short sales also can be used to hedge or offset long positions. For example, if you own a lot of tech stocks or mutual funds, you can hedge your exposure to that sector by shorting a portfolio of tech stocks -- like the
In the late 1980s, Fidelity started letting its brokerage customers short some of its
or sector funds. The mutual fund mammoth suspended that practice for a few years but resurrected it in the early 1990s. (
, following its acquisition of broker
, will let you short about 30 funds but only over the phone -- not online.)
If you really want to short a Fidelity Select fund, there are a lot of steps you have to go through.
First of all, investors can short only 11 of Fidelity's 39 Select funds.
When the list of funds that could be shorted was originally compiled, the 11 funds that made it were among the most popular at that time, and there were a large number of shares held in brokerage accounts, says a Fidelity spokeswoman. The firm has kept the original list of funds and hasn't expanded it, she says, adding that the program is very small.
To short Fidelity's Select funds, you must have an account with Fidelity's brokerage arm. Regular brokerage commissions are paid on the short sale and the repurchase, but shorts are exempt from Fidelity Select funds' 3% sales charge. (The firm's standard online commission is $25 a trade.)
You'll also need a margin agreement with the firm. (When you buy stocks on margin, you're using borrowed money. In the case of shorting, you aren't borrowing cash but securities.) Initially, your account also must contain cash or securities equal to at least 50% of the market value of the shares sold short plus the proceeds of the short sale.
Fidelity only prices these sector funds every hour on the hour during the trading day. You can place an order any time during the trading day but will only get the price that's calculated at the following hour. If you place a trade at 1:20 p.m., you'll get the next price, which is calculated at 2 p.m.
For the aggressive trader, this pricing schedule can be a huge disadvantage -- particularly when the market is volatile.
Also, Fidelity allows investors to short its sector funds only on a price increase of at least $0.02 or at the last price, if it was up at least $0.02. This restriction is called an "uptick provision" and simply means that you aren't allowed to short the funds when their prices are falling. (In general, you aren't allowed to short individual stocks on a downtick either.)
Lastly, the Fidelity Select funds are actively managed funds, so you'll never really know at any given moment exactly what stocks you're shorting.
Now let's look at exchange-trade funds and stock baskets.
You can short any of the existing exchange-traded portfolios, such as
, the Nasdaq 100 tracking stock
Sector Spiders and
HOLDRs. And you can short them on a downtick, or when their prices are dropping.
You can short them through any number of brokerage firms (assuming that shares are available for borrowing).
These portfolios are priced continuously during the day, like a stock, so you can get in or out as fast as your broker can fill your order. Plus, they track specific indices (or baskets of stocks, in the case of HOLDRs), so you should always be able to know exactly what you're shorting.
Keep in mind that many of the dangers of shorting a single stock still exist when you short a basket of them.
You get an unlimited downside and limited upside. That is, you make money when a security falls, but it can only fall to zero -- putting a cap on the amount of money you can theoretically make.
However, there's no limit to how much a stock or portfolio can rise, thereby making the losses on your short limitless.
One safer way to short the market with mutual funds is to buy shares of a fund that sells short. Your possible loss is then limited to the amount of money you invested in the fund.
Rydex Ursa and
ProFunds UltraShort OTC are two mutual funds designed to go up when the market goes down.
Then again, maybe you're still bullish.
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Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.