Until this recent dip in the S&P 500 Index ($SPX), investors could be forgiven for forgetting about risk management. The period since 2009 has been mostly one of bliss for S&P 500 investors, marred temporarily by a 5-week crash in 2020, a 9-month drubbing in 2022, and a regular series of brief market corrections. But history indicates that is not the whole story of equity investing.
For instance, here we are in the 26th year of this century, and over nearly half that time, the S&P 500 gained about zero. The double-bear markets of 2000-2003 and 2007-2009 made sure of that. So, what if another extended bad spell is upon us?
Investors whose experience with the stock market goes back only as far as the past 10 years might be tempted to assume that investing in the S&P 500 is all puppy dogs and roses. But the fact is, historically speaking, it can be more like a barking dog.
That’s where pros, and now self-directed investors, have made the effort to research and consider if and how specialized ETFs known as “inverse” or “bear” funds can cushion the blow during stressful times in the stock market. With the S&P 500’s recent 3% drop over the past five trading days, reasons are mounting for many to better understand how these ETFs work.
There are more than 100 U.S.-traded ETFs that allow investors to try to profit from a decline in a major stock index. Some are leveraged, which brings additional complexity, and some are designed to move opposite the price of a certain stock, bond or commodity sector, theme, or even an individual stock. But to keep it simple this time around, let’s focus on one of the first “single inverse ETFs,” the largest of that set from ProShares that debuted way back in June 2006.
About ProShares Short S&P 500 ETF
The ProShares Short S&P 500 ETF (SH), an “old timer” in this category of ETFs, now has over $1 billion in assets under management.
Despite the allure of a new breed of more leveraged vehicles, this “old timer” trades around $200 million a day on average, so it is plenty liquid for those looking to hedge their stock exposure.
As if to conjure up memories of 2020 and the pandemic crash, the S&P 500 recently peaked on Feb. 19, the exact same date it did 5 years ago, which started a 33%, 5-week plunge in that headline index. Then as now, SH did what it was supposed to do. It gained about 6% when the market fell by roughly that amount.
And over the past 12 months through Friday’s close, SH’s 10% decline looks pretty good versus the S&P 500’s 12% gain.
SH ETF Risks and Rewards
Conventional wisdom surrounding ETFs like SH, which simply seek to provide a return opposite of an index like the S&P 500 are only viable if held for a single day. While the ETF, strictly speaking, aims to track a return of -1x the target index on a daily basis, SH has often provided a similar or greater benefit over weeks or months.
For instance, during that aforementioned period in 2020, when the SPDR S&P 500 ETF Trust (SPY) dropped more than 33%, SH gained 42%, providing more than a 1-to-1 offset to the risk of the stock market.
SH does not “short” the stock market by borrowing stock and selling it short. Instead, it achieves and maintains its “anti-S&P 500” position by entering into swap contracts with several different counterparties, who are major global investment banks. It also shorts futures. That’s all backed by US T-bills as collateral.
Note that as the S&P 500 sustains a very long bull run, the math of investing loss can work against investors. In an extreme case, if one had bought SH 10 years ago and did their “Rip Van Winkle” impersonation, falling asleep for a decade, they would awake to find out that 95% of their investment was gone.
The Bottom Line on This Bear Market ETF
This is clearly a case of “know what you own,” since the natural inclination for investors is to buy a stock or ETF in hopes its price goes up in value. SH goes up in value when the S&P 500 goes down.
There are many trading and investing strategies where SH and other inverse ETFs can play a helpful role. They can be used to offset risk in a stock portfolio, provide defense alongside an otherwise offense-minded set of ETFs, or can be used as a vehicle to try to profit from down markets.
