An exchange-traded fund (ETF) refers to a basket of securities trailing a commodity, index, or a basket of assets. Similar to an index fund, it trades like a stock on an exchange and experiences price movement throughout the day on the open market as these are purchased and sold. Such funds have lesser benefits than conventional mutual funds. Many investors opt to short ETFs to somewhat protect their portfolios. However, shorting on ETFs also has disadvantages.

But worry not, investors, for you can counter the downfalls of shorting ETFs.

Who shorts ETFs? The following do so: sophisticated investors, hedge fund managers, and professional money managers, as well as conservative and aggressive investors.

Why do investors short ETFs? There are several reasons as to why many investors short ETFs. One is this fund has many features, making it appealing for selling short. These are an aggregation of thousands of firms, encompassing dozens of stocks. Such funds are also created to monitor the index. There are various kinds of ETFs, which are classified according to an investment theme.

It can be purchased online or through a brokerage company done within a day on the stock exchange. ETFs are diverse, making them exempt from the uptick rule. The Securities and Exchange Commission (SEC) imposes this rule to regulate short selling, stating the security’s price must have first increased from the last sale before shorting it. Doing so aims to offset or lessen risk in a portfolio.

How to short ETFs? It involves borrowing a number of shares of stocks or an ETF you want to sell. Normally, the process occurs within a margin account, an account in which the company lends you money to buy the securities. The broker may borrow the securities from another client or firm, while the ETF is sold on the market. The seller incurs interest on the loan and will need to pay any dividends to the lender, hoping the market will decline. The fall will drop the price, allowing for the securities to be acquired at a lower price.

What are the advantages and disadvantages of shorting ETFs? Shorting ETFs provide more trading flexibility. Being a highly tax efficient, these funds defer capital tax gains. Going short on ETFs is also less risky because investors lose less money. The fund is not affected by short squeezes, which takes place once the stock’s price begins to escalate quickly when the supply is lacking. Traders going short on their positions attempt to obtain stocks to avert losses. However, it only increases the prices more, worsening the losses of those who shorted and did not close their positions. ETFs suffer not from this since the number of shares can be raised on any given trading day.

On the other hand, going short on the ETF is not always the best decision. Investors may find it hard to execute, which can result to higher risks if this is not done on a right timing. Since this is easier to trade, investors can tend to make wrong decisions, especially those who are not savvy. They may also encounter difficulty when placing bets with this fund because it can be exposed to limitless losses. Not every ETF can be shortened, and certain funds are difficult to short, as it is hard to do so in small numbers.

In the event shorting ETFs won’t work, inverse ETFs, or short ETFs, is the answer. These are designed to go up in case a specific sector or index decreases. It provides all the advantages of short selling but do not require making a direct short sale. A margin account is not needed; therefore, investors can avoid some fees and costs. Using this fund enables an investor to gain profit from the market and can help them hedge exposure to risk in their portfolio. But inverse ETFs are not advisable for increasing markets, requires skillful market timing, and performance history is limited since the fund is almost new in the market.