Global economies move in bullish or bearish cycles that can span many years or even decades (as is the case with Japan). While many international investors are familiar with buying international exchange-traded funds (“ETFs”) to capitalize on growth opportunities, the idea of betting on a country or region’s short- or long-term economic decline may seem a bit foreign, or worse, immoral.
In this article, we’ll take a look at how international investors can bet on a country’s economic decline using international ETFs and a practice known as short selling.
- Few investors are familiar with the ways to bet on a country's decline.
- Short-selling and put options provide two great ways to place these kinds of directional bets, although they involve a lot more risk than long-term investments.
- Short selling involves a greater degree of risk relative to traditional long-term investing since it involves borrowing or margin.
- Put options require investors to try to “time the market” instead of simply waiting for their thesis to play out.
Investing With International ETFs
The easiest way for the average investor to gain exposure to international markets is using exchange-traded funds (“ETFs”). By holding a diverse basket of securities in a single security traded on a U.S. exchange, these so-called “Country ETFs” provide instant diversified exposure to an entire country’s economy through its publicly traded equities, with a relatively low expense ratio compared to the alternative.
International investors that believe a country’s economy is going to expand may want to consider purchasing these ETFs as a way to capitalize on that growth. When an economy is growing, companies operating within its borders often realize higher revenue and profitability over time. The decision does, however, depend on the existing valuation of these equities, which may already account for the growth and be lofty.
How to Profit From a Downturn
Short selling involves borrowing and then immediately selling equity with an agreement in place to repurchase it in the future. For example, a broker that’s holding AAPL stock on behalf of some of its clients may borrow that stock to a short seller who will acquire and sell it for cash. If AAPL stock declines in value, the short seller can then repurchase it for less than they sold it for and generate a profit.
The concept of short selling can be applied to country ETFs since they trade just like any other U.S. equity. International investors that believe a country’s economy is in trouble may short sell that country’s ETF by borrowing and then immediately selling the ETF for a profit, betting on the fact that they will be able to repurchase the equity and pay back the loan at a lower price over time.
Important Risks to Consider
Short selling involves a greater degree of risk relative to traditional long-term investing since it involves borrowing or margin. For example, suppose that an investor short sells a country’s ETF and is wrong about its decline. If the ETF appreciates in value by 50% over the course of the year, the investor is still obligated to repurchase it and take a 50% loss on the position.
The biggest disadvantage stems from the fact that short selling involves the potential for unlimited losses and only 100% gains since a stock price can only fall 100% but can rise indefinitely. These dynamics are the exact opposite of long-term investing and they present investors with an adverse risk-reward ratio from the start. But still, many investors consider these risks worth taking.
Alternatives to Short Selling
International investors may want to consider several alternatives to short selling before taking on the risk. The most common alternative is purchasing put options, which give investors the right to sell at a certain price on or before a certain date. By purchasing a put option, investors can profit from a decline by having a guaranteed selling price that may be higher than the market price.
The downside of using options is that they all eventually expire worthless, whereas a short position can be technically left open indefinitely. In other words, put options require investors to try and “time the market” instead of simply waiting for their thesis to pay out. The tradeoff is that they involve significantly less capital investment, a predictable risk-reward profile, and potentially greater leverage.