Making money off the stock market in the past year has been easier than most people think.
All you had to do was place an educated bet against Wall Street's performance, then put your money into an inverse exchange-traded fund—also known as a "bear" fund—and watch the returns roll in.
OK, so it sounds easier than it really is.
Inverse ETFs are somewhat complicated instruments that pay off when the market falls. Sometimes it's on the entire market, other times on various sectors or indexes within the market—making the past year's selloff a good time to be betting against stocks.
The gains have been nothing short of eye-popping, especially when many investors have seen their portfolios cut in half by the market carnage. Some bear funds soared nearly 80 percent last year, while others are up 39 percent this year alone.
The big question for investors is whether the party can continue, and how they can get in on the action. While ETFs trade similar to stocks, there's a lot more to learn about the funds.
"It's not too late," says Matthew Tuttle, president of Tuttle Wealth Management in Stamford, Conn. "Once we figure out where the trading range is, the inverse ETFs can be used to scale into them once we get to the upper end of the range."
Calculating the trading range is critical for those betting against the market.
Many portfolio managers, Tuttle included, are staying away from inverse ETFs for the time being as they await a much-expected and much-delayed bear market rally. Stocks have fallen 25 percent in 2009 alone, causing many market experts to think that a sharp move higher is likely, even if it is only temporary until a true bottom is formed.
Some pros were even saying Tuesday's big upswing was the beginning of a bear market rally.
"We've gone down so much so far this year. We really haven't had any sort of bear market rally," says Dave Rovelli, managing director of US equity trading at Canaccord Adams in New York. "We've been straight down since the new year. I think we had one or two up days. You could see a significant rally."
But those who caught the inverse ETF train when the market began its plunge have had a tremendous ride. Some funds have gained as much as 40 percent this year alone, while even many of the weaker sisters among the group have seen returns in excess of 10 percent.
A few to consider:
- ProShares UltraShort Financials (AMEX: SKF), up 39 percent in 2009 after gaining just 3.6 percent in 2008.
- ProShares UltraShort MSCI EAFE (economy-based) (AMEX: EFU), up 27.4 percent in 2009 and 51.9 percent in 2008.
- ProShares UltraShort Industrials (NYSE: SU), up 22.6 percent in 2009, and 77.7 percent in 2008.
- Rydex Inverse 2X S&P 500 (NASDAQ: RSW), up 15.4 percent this year, and 69.3 percent in 2008.
The 2X, or double-inverse funds, are relatively new to the market and present an interesting challenge to investors.
While they pay double on the opposite moves of the indexes they track, holders of the funds can get stung on a rapid swing in the other direction.
That's why some advisers are holding them at arms-length at least for the time being.
"We don't use them, just because they haven't been around long enough to really be able to model over a 10-, 15- or 20-day period," Tuttle says. "Those are much more suited to making day trades."
If the bear rally does come, those holding 2X or 2.5X funds could get hammered.
"They are derivatives, and if you start looking at them you want to be a trader on those things," says Bradford Pine, an adviser at Cantella & Co. in New York. "As the longer term trend happens it starts eating away."
Indeed, one of the biggest problems with using ETFs is educating investors, many of whom don't understand how the funds work, particularly the risks involved.
As Pine says, the funds are derivatives and therefore contain a basket of ingredients with which investors must familiarize themselves. An ETF that says it tracks basic materials, for instance, could contain chemical stocks as well as metals and more traditional components. Similarly, some financial ETFs are weighted heavily toward particular institutions.
Also, because the funds are new some of them trade on very low volume and can thus be highly volatile.
"They're much more complicated than people understand. You have to be an educated investor," says Chapin Hill Advisors' Kathy Boyle, who often leads seminars on ETFs for other investment professionals, many of whom "don't quite know how to wrap their arms around this."
Attaching the word "short" to the ETFs also adds to the confusion.
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Buying a "short" ETF is a process similar to buying a stock, with the fund tracking an index such as the S&P 500 or one of its sectors and paying proportionately for moves lower in the index. It is a different animal than short-selling a stock, which occurs when one investor borrows shares, sells them to someone else, then buys them back, hopefully at a lower price that generates a profit from the original selling price.
Interestingly, as the growth of short ETFs has blossomed, many market pros say short-sellers are not to blame for the market's leg down in 2009. A year ago, many in the market blamed short-sellers for the demise of Bear Stearns and the market contagion that followed.
"I really would attribute the big decline to A) the ongoing loss of confidence, B) the buyers' strike, and C) it's not the earnings that keep coming in, it's the future solvency of any company," says Andrew Wilkinson, senior strategist at Interactive Brokers. "You can't blame the short sellers this time around."
The absence of a short selling burst is a trend likely to continue, even as many see another leg down for the market coming after the bear market rally, which some think will occur if the government suspends mark-to-market accounting or reinstitutes the uptick rule.
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Boyle thinks the Standard & Poor's 500 could eventually fall to 545 before summertime, while Merrill Lynch analyst David Rosenberg sees 600 as making the floor later in the year. Todd Salamone, director of trading at Schaeffer's Investment Research, said 600 may not even be steep enough as the lack of despair continues to prevent a true bottom.
In such a climate, the short ETFs are likely to prosper.
"I would be doing the opposite of what people are doing," Tuttle says. "That's where you're going to make money on these inverses.
"I would not be doing it now, because I do agree we are going to see a bear market bounce and I don't want to get caught short. We could be in line for one of those up 10 percent days."For more stories from CNBC, go to cnbc.com.