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How to profit from falling markets?

Investment | ISAs Helpful? 13

Asked by mrhat, submitted 06 September 2011.

Open Quote I want to short the equities markets, preferably in my investment ISA (partly to hedge risk and partly because I feel bearish). For job-related compliance reasons I can't do spread betting. The best idea I have so far is to by an 'inverse ETF' that goes up when the S&P500 goes down, and vice versa.

Some questions:
* Are inverse ETFs a good idea? Anything particular I should know about them?
* Are they ISA eligible?
* Can you suggest any other ways to get short exposure to a major equities index without spread betting?

End Quote

Answered by Justin on 14 September 2011

'Inverse' or 'short' exchange traded funds can be held within ISAs provided they're listed on a stock exchange 'recognised' by HMRC - can't think this will be an issue. You'll just need to use a self select ISA via a stock broker who allows shares to be held (e.g. x-o.co.uk, interactive investor etc), assuming you don't already.

In theory short ETFs are very simple, they track a stock market index in reverse. So for every point the market falls they increase in value by the same amount - i.e. you make money when markets fall and lose money when they rise.

However, the vast majority (if not all) short ETFs track the index on a 'daily' basis, resetting the index each day, which can lead to compounding of returns or losses. For example, suppose the FTSE 100 falls by 5% on day 1 then rises by 10% on day 2, a 100p investment would rise to 104.5p. A Short Daily ETF would rise to 105p on day 1 then fall to 94.5p on day 2. The Index has risen 4.5% overall but the ETF lost 5.5%, i.e. it doesn't directly track the index (in reverse) over periods greater than a day. So they're arguably less suitable for longer term investing than day trading.

You'll also need to factor in dealing costs (minimal if you use a low cost online broker), annual ETF charges (probably around 0.5%) and a bid/offer spread (difference between buying and selling price). I've heard that the latter can at times become a little excessive because short ETFs aren't always that widely traded - this shouldn't be much of a problem but perhaps check out spreads before buying to get a feel for how much it tends to be.

When it comes to choice, there are plenty of short ETFs in the US but they're thin in the ground over here.

db X-trackers offers a FTSE 100 Short Daily ETF (other indices are available), which charges 0.5% a year, while ETF Securities offers a FTSE 100 Super Short Strategy (2x) ETF which offers double inverse exposure to the Index.

So for greater choice you'll need to look to the US ETF market. I don't think there's any practical reason you can't hold them if your stock broker allows you to trade them.

You might also want to read my article discussing the 'hidden' risks of ETF investing. Not necessarily something to be too worried about, but certainly worth being aware of.

You might look at contracts for difference (CFDs), which are similar to spread betting but vary in that profits are taxable (spread betting is tax-free), dividends are paid (spread betting incorporates into the price) and CFD pricing is more like share dealing (spread betting focuses on point movements). It may be you're not allowed to use CFDs either for compliance reasons, but worth checking. Just remember that both are leveraged investments, so you can lose more than your initial stake.

Please note this answer does not constitute a recommendation or financial advice and should not be relied upon when making specific investment or other financial decisions. You should always undertake your own research into whether a product or service is appropriate for your needs and, if necessary, use a qualified professional adviser.

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