One of the major selling points for exchange-traded funds is that they can be sold short. Given the recent tenor of the stock market, that should be a big plus -- after all, it's much easier to bet on a decline in a portfolio of stocks than to make separate bets against each individual holding.But the truth is, it's not as easy to sell an ETF short as the industry would have you believe. Unlike mutual funds, which are issued and redeemed once a day by their sponsors, ETFs are bought and sold on an exchange, like stocks. In theory, that means you can short them as easily as stocks, borrowing the shares and selling them in the hopes of buying them back at a cheaper price when its time to repay the loan. Say, for example, you borrow and resell 100 shares at $30 for a total of $3,000 and they subsequently fall in price to $20; you can then buy them back for $2,000, repay the loan and pocket the $1,000 difference, minus transaction fees. (By the same token, if the stock subsequently rises to $40 a share, you'll be out the additional $1,000 needed to repay the loan.) Of course, some stocks are easier to borrow than others. Investors typically rely on brokerages to lend them shares held by other clients, such as mutual funds or other big institutions. If a stock has a small market capitalization or is already heavily shorted, it can be hard to find someone willing to lend it.
ETFs shouldn't have this problem. Brokers, or in this case the specialists who make a market in ETFs, don't have to go searching for them, because they can always create new shares by assembling the component stocks. But they typically only do this in blocks of 50,000 shares or more. So if you want to short a much smaller number, say 1,000 shares, the specialist would be left holding the remaining 49,000 on its books. David Fry, founder and publisher of ETF Digest.com, an online investment newsletter, says that's not an attractive proposition for brokers; keeping large inventories on hand ties up capital and exposes them to additional market risk. That means it's no easier to borrow shares of small, illiquid ETFs than it is to borrow shares of small, illiquid stocks. For example, Fry notes that the PowerShares Listed Private Equity Portfolio ( PSP) would seem like a good candidate to short, given how tough it has become for
private-equity firms to raise money for buyouts. The fund has already lost 10.5% this year. But in reality, he says, PSP is especially hard to short, because brokers are unable or unwilling to lend the shares. He says the same is true of many other recently minted ETFs that track niche markets and have less than $100 million in assets. "The brokers are lazy," says Fry. "They won't call around for you to find 200 shares to short. You may as well be calling the post office to help you. It's not going to get done." Of course, the bigger the transaction, the more likely brokers are to be helpful. Gary Gastineau, managing director of ETF Consultants, a consulting firm in Summit, N.J., says securities lending is one of the least automated activities in the securities industry. "You call a broker and say you want to sell short 1,000 shares of a stock, he says you can't do it, it's too hard to borrow. If you say I want to sell short 100,000 shares, the broker will say 'consider it done.'"
In the end, it may be easier to buy ETFs that do the shorting for you. ProShares has a stable of 29 ETFs that move in the opposite direction of an index or track two times the inverse performance of a benchmark. The funds charge an expense ratio of 0.95%. The options are still fairly limited compared with the number of ETFs you might want to sell short. But the beauty of buying a short ETF is that you don't have to set up a margin account. "This is shorting made easy," says Michael Sapir, CEO of ProShares. (To watch a video interview with Sapir about inverse ETFs, click
here.) By shorting index futures contracts and holding swap agreements, or contracts between two parties to exchange a revenue stream, ProShares' funds can produce a return that closely equals the opposite of a variety of indices. For instance, if the S&P 500 falls 5%, the Short S&P 500 ( SH) should rise 5%, while the UltraShort S&P 500 ( SDS) gets double the negative return. Likewise, the Short QQQ ( PSQ) tracks the inverse performance of the Nasdaq 100 Index, and the Short Dow30 ( DOG) gives the opposite return of the Dow Jones Industrial Average. ProShares also offers short plays on value and growth styles, such as the UltraShort Russell 1000 Value ( SJF), as well as on market sectors, such as the UltraShort Financials ( SKF) and UltraShort Real Estate ( SRS). Currently, ProShares is the only company that offers ETFs that short indices. But it may soon have competition. Rydex has filed plans with the Securities and Exchange Commission for 64 inverse ETFs. ProShares itself has an additional 58 in registration. To find out how to use inverse ETFs in your portfolio, read here.