Just a few years ago, investors interested in profiting from a downturn in a specific corner of the market had to borrow shares from their broker, short individual companies — and then hope they didn’t pick a stock that went against the grain and moved higher. But now, betting against banks, small-cap stocks, or even entire market averages is just one convenient ticker symbol away.

     So, what exactly is this revolutionary new way to short the market? It’s done by using an inverse exchange-traded fund (ETF)

     For the most part, I haven’t placed terribly much emphasis on inverse funds in the past. After all, I’m generally a long-term investor, and ultimately the market goes up far more than it goes down. However, there are certainly times when this group can be very appealing, particularly in this market environment.

ETFs: A Brief Overview
     Before we talk about the hedging advantages of inverse ETFs, let’s quickly review what ETFs are, and how they work.

     Exchange-traded funds are securities that closely resemble index funds, but can be bought and sold during the day just like common stocks. These investment vehicles allow investors a convenient way to purchase a broad basket of securities in a single transaction. Essentially, ETFs offer the convenience of a stock along with the diversification of a mutual fund.

     From a humble start in the early 1990s, the ETF business has exploded, particularly over the past several years. There are now over 700 ETFs with $450 billion in assets.

     ETFs boast several major advantages over mutual funds and common stocks, including diversification, flexibility, low cost, liquidity, and tax efficiency.

Going Short the Smart Way
     Inverse ETFs (or short ETFs) operate on the same basic principles, except they are designed to move in the opposite direction of an underlying index — meaning shareholders actually profit when the benchmark tanks. In other words, these funds were made for markets just like this one — the lower the market retreats, the higher these funds advance.

     But it doesn’t just stop there. Some ETFs can even return double the inverse of what the market is doing. Let’s say you buy shares of the UltraShort S&P 500 ProShares ETF (SDS). If the S&P 500 drops -5%, then SDS gains +10%. Keep in mind, these funds compound daily, so if you invest for longer (a week, a month, a year) the returns won’t line up.

     These ultra-short funds are able to double the inverse performance of indexes by using leverage. The math doesn’t always work out exactly, but you can usually expect it to return double the inverse within a reasonable range. The tradeoff, however, is that these funds can be incredibly volatile, and if you are wrong you lose twice as much — so only consider this if you think you’ll have the stomach for it.

     Think of inverse ETFs as a type of insurance policy for your portfolio. In other words, investing a modest amount in one of these funds can be a useful way to protect profits in certain asset classes or simply hedge against further market declines. And like any insurance premium, you hope it’s never needed; ideally, the market reverses course and you end up realizing a small loss on the position that is more than offset by gains elsewhere.

     But the events surrounding this recent downturn should clearly illustrate that sometimes unexpected circumstances can materially impact your portfolio, in which case an inverse fund can help soften the blow… and in some cases, even generate enormous profits.

     For example, on September 30th, four days before the Dow went sub-10,000, I sent a special newsflash to my ETF Authority readers identifying 14 securities that could skyrocket as the market heads south.

     As you can see, most of these have done exactly what they were designed to do in this rough market:

                  *Source: Bloomberg. Total returns from 9/30/08 – 3/5/09

     You may think you’ve missed the boat on short ETFs, but think again. With the market coming off of depressing lows, we may now may be experiencing a “dead cat bounce,” with the market rallying in an attempt to form a new bottom.

     With all this in mind, readers might want to consider adding an inverse fund or two to help smooth out some of this unprecedented market volatility.