2008: A Great Year for Short-Sellers

By Eric Roseman 

For the first time since 2002, investors who sell short or bet against rising stock prices are basking in some real profits.

Betting against the market using reverse index funds is a highly-skilled discipline that the majority of hedge funds and investors fail to master. Most investors, even equity long/short hedge fund managers, are typically long-only investors. They're getting trashed along with everyone else in this lousy market.

Thus far, 2008 has been the first year stocks have declined since 2002. The S&P 500 Index has declined 13% this year while the MSCI World Index has plunged 17%. Worse, developing economies have been ravaged, led by stunning losses in China, Russia and India among many others. The MSCI Emerging Markets Index is down a dizzying 21%.

If you managed to speculate with reverse indexes or exchange traded funds (ETFs) that bet against these and other indices, then you're sitting pretty. Even better, some of these reverse ETFs have twice the inverse correlation, meaning that they can boost your returns in a bear market.

For example, the ProSharesUltraShort MSCI EAFE ETF (EFU) has surged 45% this year as the benchmark EAFE Index (Europe, Australia and the Far East) has tumbled 21% without leverage. If two times leverage isn't your game, then EFZ or the ‘ProShares Short MSCI EAFE' ETF, can still pack a big punch in a bad year for international equities.

The safest and most responsible way to use reverse-index ETFs is to hedge or protect your equity portfolio in a bear market.

But figuring out exactly how much you should allocate to these volatile products can be a tough balancing act. Your answer depends on how much exposure you have in stocks - domestic and foreign - and how much you have invested in fixed-income, commodities, currencies and other assets. Basically, your asset allocation, age, income needs and tolerance for risk will dictate this strategy.

With stocks already down 20% from their October 2007 highs, it might be too late to buy this sort of protection. But then again, if I owned a portfolio of stocks there's no way I'd leave myself without some sort of downside protection even at these low levels.

This is a bear market and we can still decline another 10% or more.

Disclosure: none

 

Comments

[irondoor91:]

Here's and example of how an investor could use the double inverse ETF's to hedge the stock-only portion of his portfolio. For illustration purposes, let's assume a portfolio of $1 million in either individual stocks or funds. Further, let's assume that the investor holds his stocks in a brokerage account that has margin borrowing available. Depending on the type of stocks held, the investor can determine which double inverse ETF would most closely track his portfolio (DXD for the Dow, SDS for the S&P 500, QID for the Nasdaq 100). He would then purchase, on margin, and amount of the double inverse ETF to equal half the $1 million stock portfolio. For example, assume that he decideds to use the double inverse ETF on the S&P 500 (SDS). Assume that it is priced at $63.29 (yesterday's close). To fully hedge his portfolio, he would purchase $500,000 of the SDS. $500,000 divided by the per share price of 63.29 indicates that he should purchase approximately 7,900 shares of SDS. To visualize how this works to hedge the portfolio, assume that his stocks decline 10% to $900,000. SDS should increase by 20% (double the inverse), to make up the $100,000 loss on the stock portfolio. If his stock selection outperforms the market, he will come out ahead. Conversely, if his stocks underperform the market he will still lose money in spite of his hedge. This analysis does not take into consideration the costs of ownership of the stock portfolio, commissions, interest paid on his margin account and the internal cost of operations inherent inside the ETF. While these inverse ETF's are one of the simpler and easier to use hedging vehicles for retail investors and have proved popular and profitable during the current stock market weakness since last October, they will more than likely disapoint investors who have no disciplined method of timing the swings in the market.

2008 Aug 28 11:08 AM