Abstract
A high liquidity, low expense ratio and the possibility to conduct arbitrage allow exchange-traded funds (ETFs) to be used for short sales. Bearish investors can also buy inverse ETFs. This paper aims to outline two investment approaches for bearish ETF investors and the differences between these two approaches; it also aims to examine the relationship between price and an indicator of volume and evaluate the final positions in selected ETFs in selected periods. Short ETFs dominate in simplicity, flexibility, paying out dividends and especially in the limited size of the loss. On the other hand, their structure, which demands daily rebalancing, causes substantial deviation from the benchmark in the long-term and leads to a higher expense ratio, and lower liquidity increases bid-ask spreads. Negative aspects of ETF short selling lie in unlimited loss, high borrowing costs, the need for margin accounts, variability of loan fees and the possibility of a transaction recall by the lender. On the contrary, margin operations enable potentially higher appreciation of capital by generating rebate rates. Our results show that with the decrease in value of the most used ETFs, short interest is growing for those funds where there is a very strong negative correlation implying hedging tendencies. Short selling proved to be a more advantageous strategy in the observed period of market downturn, as well as in 2011–2017, due to negative returns, however, by applying margin trading inverse ETFs turned out to make less losses. Sector-oriented inverse ETFs are the exception, where the largest differences between these two strategies are recorded. However, the final conclusion of the suitability of one of the analyzed strategies depends on the market volatility and the direction of the market itself.
Highlights
Great success of index investing by the traditional index mutual funds led to the creation of index funds that are traded on the stock exchange, the exchange-traded funds (ETFs)
Exchange-traded funds enable the investors to be short in broad basket of assets by the short sale of just one ETF stock
They use a variety of term contracts and reset their exposure daily. They operate on a principle of leveraged ETF and in the form of synthetic funds. Such a structure leads to a higher expense ratio, lower tax efficiency and higher riskiness compared to normal ETFs, depending on the volatility of reference benchmark
Summary
Great success of index investing by the traditional index mutual funds led to the creation of index funds that are traded on the stock exchange, the exchange-traded funds (ETFs). These types of funds offer investors even bigger benefits than traditional index funds. ETFs are traded continuously throughout trading hours, which leads to much higher liquidity Issuance of their stocks allows investors to set limit orders, to use them for collateral trading and forwards, to conduct arbitrage when the price on the secondary market deviates from the net asset value of the ETF’s underlying assets and to use them for short sales. The data for this study are taken from Bloomberg and the ETF Database
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