Exchange-traded funds (ETFs) aren't always the first type of financial instrument you may think about short selling. But because ETFs are traded like stocks, they're relatively easy to sell short. And just like with stocks, selling short ETFs involves borrowing and then quickly selling shares of the fund. This is done with the expectation of being able to buy them back for a lower price than you sold them for.
You might sell an asset short because you expect it to decline in value and you hope to profit from the completed trade. But there are other reasons as well.
Learn four reasons you might short sell an ETF.
1. Hedge Downside Portfolio Risk
Let's say you have a substantial equity or fixed-income portfolio. You to protect against a drop in one or more stock or bond markets. Selling short an ETF that includes a large number of stocks or bonds in the market or markets might be the way to go.
For instance, the SPDR S&P 500 ETF Trust is an ETF that attempts to replicate, before management fees and other costs, the return of the S&P 500 Index. This tracks the performance of 500 large-company stocks that are listed on U.S. exchanges.
For a portfolio that has diversified stock holdings from around the globe, a good choice to sell short might be the iShares MSCI ACWI ETF. This fund aims to match the performance of the MSCI ACWI Index; this consists of stocks from 23 developed and 27 emerging markets. If you have a large exposure to fixed-income securities in emerging markets, you might consider shorting the Invesco BulletShares 2024 USD Emerging Markets Debt ETF.
If a decline in the particular stock or bond market or markets you were concerned about does come to pass, your short position in a broad-spectrum ETF would offset some of the losses on the individual securities you own.
2. Hedge Downside Sector, Industry, or Commodity Risk
What if you're concerned about a decline in a particular sector, industry, or commodity? You could short sell an ETF that consists of stocks in a sector, such as health care; an industry, such as biotechnology; or has exposure to a commodity, such as crude oil.
The Fidelity MSCI Health Care Index ETF, for instance, has as its underlying index the MSCI USA IMI Health Care Index. This covers all industries within the health care sector. The VanEck Vectors Biotech ETF encompasses 25 stocks in the biotechnology industry. And USCF'S U.S. Oil Fund is a commodity ETF; it uses oil futures contracts to attempt to reflect daily price movements in West Texas Intermediate light, sweet crude, minus the firm's expenses.
3. Hedge Regional or Country Risk
If your portfolio has a good deal of exposure to a region or country, you might want to sell short an ETF that invests in that location. For instance, shorting the iShares MSCI India ETF would help offset your losses if Indian stocks took a dive. Alternatively, you could reduce risk by shorting a foreign currency ETF such as the Invesco CurrencyShares Swedish Krona Trust.
4. Hedging Derivatives
If you are trading ETF, index, or equity options, you can hedge long derivative positions by shorting a correlating ETF.
An options contract confers the right to buy or sell an underlying asset at a set price on or before a certain date. A call option gives you the right to buy the asset; a put option gives you the right to sell the asset.
For example, if you are long (have purchased) call options on the PIMCO Active Bond ETF, you could hedge your risk by shorting that ETF.
However, investors should keep in mind that this kind of strategy is risky. The risk an investor is assuming as a result of the short is much greater than the risk associated with the long option position. The option gives the right, but not the obligation to exercise.