Breaking out the short ETFs

"I'm Winston Wolfe. I solve problems." The Wolf, Pulp Fiction

If you use inverse or short ETFs correctly, they can help you out like the Wolf helped Jimmie, Vincent, and Jules.

Since 2006, there has been an explosion in ETFs that allow you to short various equity or fixed-income indexes. These instruments have given investors, particularly institutional ones who often operate under restrictions on short-selling and with minimum holding periods of 90 days for stocks, flexibility. Short ETFs could allow you to stay fully invested in an index, while laying off the risk of particular segments of that index.

For instance, last year the S&P 500 was up, but it was a horrible year for financials(which comprise nearly 20% of the index). By buying shares in the ProShares' UltraShort Financials (SKF), some of that risk would've been neutralized. ProShares and Rydex are the current leaders in pushing these products. ProShares even offers leveraged short ETFs that allow you to double the return of index. ProShares accomplishes this feat of financial engineering by using derivatives like swaps and futures. Unfortunately, not all indexes have a short counterpart, so sometimes, you'll just have to step to the sidelines and cool your heels with cash or Treasuries.

Keep in mind that shorting the market, even through instruments such as ETFs, is a difficult tactic. It requires greater vigilance and often, capital, than simply going long. As you no doubt know, the market tends to rise over time. It's a good idea to use these as a hedge and not just a directional/timing bet concerning the market or a sector.

Of course, you can also short the actual ETFs in the usual manner or buy puts/sell calls on them. However, there is an advantage to letting an investment company do your shorting for you, says Roger Nusbaum of TheStreet.com. "If you sell short an ETF, you will have to pay the dividend paid by the fund. That's not the case with ETFs that themselves go short." Plus, while you cannot short an IRA, you can buy ultra-short ETFs for your IRA. If you would like more information on ETFs, take a look at this Vanguard ETF Guide or Yahoo! Finance's ETF Center.

ProShares short ETFs and an article from SeekingAlpha.com that has a good overview of inverse ETFs.

Rydex's stable of inverse ETFs.

Roger Nusbaum at TheStreet.com's take on the double short ETFs.

Three ways to short emerging markets.