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.
Some of the funds use leverage to magnify results. When the S&P falls by 1%, Rydex Inverse S&P 500 2X ( RYCBX) rises by 2%. The leverage can provide flexibility. Say an investor has a $1 million portfolio that tracks the S&P. To protect against losses, he could put $1 million into the regular S&P inverse fund. Or the investor could accomplish the same thing by putting $500,000 into the S&P leveraged fund and invest the rest in stocks or bonds. Instead of buying an inverse fund, an investor could short an ETF, such as iShares S&P 500 ( IVV), which tracks the benchmark. (The SEC order did not bar shorting of ETFs.) But shorting has become increasingly cumbersome. In a typical short transaction, an investor borrows shares and then sells them. If the stock drops, the investor can repurchase the shares at a low price and book a profit. To short a stock or ETF, a retail investor must first establish a margin account with a broker. Then the broker must borrow the shares from an investor who owns them. In recent months, it has become increasingly difficult to borrow stocks. "Because of the concerns about credit risks, some people have been restricting the shares they will lend," says Ryan Harder, a Rydex portfolio manager. Once he succeeds in selling the borrowed shares, the short investor must monitor the position carefully. If the shares drop, potential profits climb. But if the stock rises, losses can mount. The investor could face a margin call, a demand from the broker that the client put up more collateral to back the losing position. No matter how a trade fares, it can generate plenty of paperwork and hefty brokerage fees.
By relying on inverse funds, investors can avoid all the hassles of shorting. Whether they are no-load mutual funds or ETFs, the inverse choices can be bought instantly online with a few keystrokes. No margin account is required. If a trade goes badly, there are no margin calls. The paperwork for inverse investments is the same as it is for any fund. Most inverse funds come with expense ratios of around 1%. In contrast, margin accounts used for shorting can charge up to 9% interest. Because of their flexibility, inverse funds enable bearish investors to employ a variety of strategies. Say an investor is worried about technology stocks but optimistic about Apple ( AAPL). He could buy shares of Apple and also invest in ProShares Ultra Short Technology ( REW), which delivers twice the inverse of the Dow Jones U.S. Technology Index. The trade would be a big winner if Apple rose while most technology stocks dropped. An inverse fund can provide a long-term hedge. If an investor has owned pharmaceutical stocks for years but fears the shares will drop for several months if Barack Obama is elected, instead of selling the stocks -- and possibly booking capital gains -- the investor can hedge by buying Rydex Inverse 2X S&P Select Sector Health ( RHO). An important advantage of inverse funds is they can be held in retirement accounts, such as IRAs. Retirement accounts cannot be used for ordinary short sales. By adding an inverse fund to a retirement portfolio, investors may ensure their assets are protected from severe downturns.