October 2018 was the worst month for U.S. stocks since 2011. The S&P 500 lost 6.9% for the month, and that was after a 1.1% gain to close things out on Halloween. The broader Wilshire 5000 index fell by 7.3% in October, and Wilshire Associates estimates U.S. stocks suffered total losses of more than $2.4 trillion in the recently concluded month.
Investors in gold did all right in October, as the precious metal gained 2.4% in dollar terms. After a late-month pullback, silver closed the month up only a few cents per ounce, although it did post gains in each of the first two trading days of November.
Where else could bearishly inclined investors stash their investable funds? U.S. Treasury bonds have been a traditional option, but amid the climate of rising U.S. interest rates, bonds are no safe haven. Indeed, 30-year U.S. Treasurys lost 5.4% in October. So much for the “safety” of bonds!
Of course, investors have two well-known methods of making money in declining stock markets: Short-selling stocks and buying put options. But both of these methods are problematic.
Short-Selling Explained
Short-selling stocks can be dangerous. That’s because when you short-sell a stock, you are selling shares of stock that you don’t actually own. Instead, you’re effectively “borrowing” securities from a broker and selling them onto the open market. If the share price of the stock you shorted goes down, you can “buy back” the shares you sold short (this is called “covering your shorts”) for a profit. But if the share price goes up, you’ll have to pay more to cover your shorts than you received when you did your short-selling – in other words, you’ll lose money.
The dangerous thing about short-selling is that there’s no limit to how high a stock’s price can go. If you buy a stock (this is called going “long,” as opposed to short), you know its share price can’t fall below $0, so your losses are limited – you can’t lose more than you’ve invested. But when you sell a stock short, it’s price could more than double – it could triple, or go up by even more! – and that means your potential losses are unlimited.
For this reason, stockbrokers won’t allow you to sell short unless you have a margin account. If your short positions get large enough, your broker can make a “margin call” and force you to either raise cash or cover your outstanding short positions. And because of all this, not everyone with a stock-trading account is automatically allowed to sell short – the option might not even be available to you.
Put Options Explained
Speaking of options, puts are the other popular method to make money on a declining stock. A put is an option that gives you the right (but not the obligation) to sell 100 shares of a particular stock at a particular price (called the “strike price”), on or before a particular date (the expiration date). If the value of the stock goes down, then the value of its put options goes up, since the puts give their owner the right to sell the stock at a particular price.
The first problem with put options is that you have to be approved for an options account in order to buy or sell them. Not all traders are approved.
Secondly, the value of all options (puts and calls alike) erode over time. The right to sell 100 shares of Microsoft at $100 three months from now has more value than the right to sell at that same price today. And as the expiration date of the option draws nearer, options can rapidly lose value.
Indeed, all options that expire with “out of the money” strike prices (i.e., a strike price that’s lower than the current share price, in the case of a put) are entirely worthless. Although your potential losses are limited with puts, it’s much easier to lose 100% of your investment with options than with stocks or most other investments.
ETF Solutions
Another problem with short-selling and puts is you have to determine what to short or buy puts on. There are exchange-traded funds, such as the SPDR S&P 500 ETF (SPY) that give you access to the entire S&P 500; and others like the XLK and XLE, etc., ETFs that provide exposure to particular sectors (in this case, technology and energy, respectively); and you can short or buy puts on them. But if instead you wanted to short or buy puts on a custom array of stocks and ETFs, then doing so would be prohibitively expensive for most investors.
Fortunately, there are several choices of ETFs that can help individual investors make money in declining stock markets without having to gain special clearance to sell short or trade options. These ETFs do the short-selling for you, and since you are merely the owner of the ETF shares, your losses are limited to the amount you invest.
One of the funds shorts the entire S&P 500, but the others have selective methodologies – either quantitative (according to formula) or qualitative (up to the individual discretion of the fund managers).
Five bear-market ETFs on the market today, in order of their performance in October, include:
- The AdvisorShares Dorsey Wright Short ETF (DWSH);
- The AdvisorShares Ranger Equity Bear ETF (HDGE);
- The ProShares Short S&P500 ETF (SH);
- The Virtus Enhanced Short US Equity ETF (VESH); and
- The WisdomTree Dynamic Bearish US Equity ETF (DYB).
Dorsey Wright Short ETF
Topping the list is the AdvisorShares Dorsey Wright Short ETF (DWSH). The fund, which only launched in July, uses a proprietary stock-ranking methodology that identifies the weakest 80-100 mid- to large-cap stocks, and shorts them and them alone. Its portfolio is updated every week.
During the month of October, while the S&P 500 lost almost 7%, DWSH gained more than 11.3%. For the three months ending October 31, the ETF was up 13.1%. Those are some pretty outstanding returns!
Amazon, Apple, Microsoft, and Netflix accounted for more than 84% of the S&P 500’s gains the first six months of 2018. Although DWSH wasn’t yet trading, it wouldn’t have held any of those stocks in its short portfolio if it had been. Why short the entire market if you can exclude stocks that likely to perform well?
Ranger Equity Bear ETF
AdvisorShares also claims the #2 spot on my list with its Ranger Equity Bear ETF (HDGE). Unlike DWSH, which uses a data-driven quantitative methodology, HDGE features hands-on management from hedge-fund veterans John Del Vecchio and Brad Lamensdorf. The two men perform forensic analysis of companies’ financial statements, targeting firms that are “pulling forward” their revenue in expectation that those stocks will suffer declines in the future, when the accounting chicanery is discovered. The ETF’s stated objective is to post gains of greater than the S&P 500’s losses in down markets, and losses of less than the S&P 500’s gains in up markets. This objective was achieved in October, when HDGE gained more than 8.4%.
The HDGE ETF has been operating since 2011, and since we’ve been in a multi-year bull market for stocks since before the fund’s launch, its long-term performance numbers are deep in the red. But staying true to its goal, HDGE has generally posted losses less than the S&P 500’s gains. Over the past five years, the ETF has lost an annualized 10.6%, while the S&P 500 has gained 11.3%. But as in the most recently concluded month, HDGE has performed exceptionally well during most down markets: when the S&P fell 9% from April 2 to June 4 in 2012, for example, the ETF gained 22%.
ProShares Short S&P500 ETF
When I was reviewing the AdvisorShares Dorsey Wright Short ETF (DWSH), which selects only the 80-100 weakest performing mid- and large-cap stocks for its short portfolio, I asked: Why short the entire market if you can exclude stocks that likely to perform well?
It was intended as a rhetorical question, but now I have occasion to answer it: Because you’re not sure which stocks are likely to perform well. Shorting the entire market, under this thinking, hedges your bets, and that’s what the ProShares Short S&P500 ETF (SH) lets you do.
SH gained 7.1% in October. For the 5-year period ending October 31, the ETF was down 11.2% — which is to be expected, since the S&P 500 gained 11.3% over that same period of time.
The problem with SH is that in addition to shorting market laggards, you’re also betting against the Amazons, Apples, Microsofts, and Netflixes of the world. Then again, with Apple and other tech stocks recently suffering stiff declines, maybe that won’t be such a bad thing going forward.
Virtus Enhanced Short US Equity ETF
The Virtus Enhanced Short US Equity ETF (VESH) has an interesting methodology: Half of its short portfolio is in S&P 500 futures, betting against the broad market; while the other half focuses on the market’s five weakest sectors.
Well, interesting though it may be, the strategy wasn’t as effective in October as the others reviewed thus far: VESH posted gains, but at +4.4%, they were well under the simpler broad market strategy of the ProShares Short S&P500 ETF (SH).
For the year ending October 31, the ETF was down 7.9% (compared to the S&P 500’s gains of 7.2% over the same period).
WisdomTree Dynamic Bearish US Equity ETF
Finally, we have October’s worst-performing ETF of the bunch, the WisdomTree Dynamic Bearish US Equity ETF (DYB). But although the ETF lost 2.18% in October, it doesn’t mean it should necessarily be ruled out: That’s because the ETF isn’t a purely bearish play, but instead switches from bullish to bearish dependent on market conditions.
Obviously, such a strategy runs the risk of not making timely enough adjustments. But for the year ending October 31, DYB had gains of 2%, which is much better than any of the other ETFs reviewed that have been trading for at least one year.
Conclusion
Gold bugs, Fed-haters, and other hard-money curmudgeons – myself included – have sounded like broken records for going on a decade now. I, personally, have predicted about 200 of the last 2 stock-market crashes. But while my bearish bent has caused me to miss out on much of the stock market’s rally, I haven’t been foolish enough to hold on to my bearish bets. And while the U.S. equity market has tripled since hitting its post-Financial Crisis lows, its declines during the next mega-crash could be much deeper and faster than the rise.
Is the mega-crash already underway? It’s too early to say. But rather than just staying out of the stock market when you think it’s primed to fall, these short-selling ETFs can help you capitalize off your intuition. We will be vindicated. One day. And it would be a shame to blow the opportunity.