Funds aren’t constructed with the aim of losing money.

One could make an argument that volatility ETFs are an exception to that rule, but that’s a discussion for another day. Fortunately that infamous Dutch invention - short selling - allows us to make money from the downside of any stock or fund.

The golden rule to short selling is a simple one: be quick.

Short positions can be dangerous and costly to maintain overnight, so tend not to make good buy-and-holds. Inverse ETFs rarely post positive multi-day returns as slippage occurs between holding periods and leads to a costly compounding effect.

Except, that is, this past year. In 2011 long-term short selling has been a surprisingly effective endeavour.

EURO STOXX ETF, XSSX.L is a case-inpoint. It’s up 6% over the past 12 months. While far from perfect – the reference EURO STOXX index is down 16% over the same time – it nonetheless raises an interesting idea.

Can short selling now be declared a long-term buy-and-hold approach? In February 2011, Robert Buckland at Citigroup declared the cult of equity dead. Not twelve months later, has the cult of inverse equity been birthed by XSSX.L and its brethren?

Still not convinced? Note that the Equity Short Bias index is the top performer of all Barclay Hedge indices year-to-date.

However, shorting EURO STOXX, while a success in 2011, isn’t the easiest way to make money in a bear market. It’s too high beta – rising 12% in the past week alone. One can point to at least five similar spikes in the past six months alone.

Our shorting candidate needs to impede those runs while still providing full participation on the downside. The innovation of derivatives has afforded us just such a candidate.

Duck and covered calls

To avoid being spiked out of trades, we ought to avoid high beta shares.

Unfortunately, markets are behaving in a binary, highly correlated manner – the JCJ Implied Correlation index has risen nearly 100% trough-to-peak this year and continues to trade near highs. Such spikes lack staying power, but you see the problem: jump-risk in all equities is equally balanced on the up- and down-side. This in itself raises interesting questions about the future of skew, but let’s stay on topic for the moment.

We need a fund that will participate in the downside, but not the upside. We need a fund that structurally forgoes participation in equity gains.

Thus, I suggest shorting a listed covered call fund: the Madison/Claymore Covered Call & Equity Strategy fund is my preferred candidate. Average daily volume ranges from 50,000 to 100,000 shares. It also has a consistent stream of short interest, so your broker ought to be able to find some carry.

Covered call funds are those where the owner overwrites. That is to say sells a call option on a stock that one already owns.

The strategy has been popular ever since options became listed in 1973. It’s considered to be a conservative trading strategy that generates extra income while partially hedging downside equity risk. The hedge is the option premium that supplements income, providing a cushion against drops in equity prices.

There is a catch. Writers of covered calls are receiving this compensation for giving up the upside potential of their equities. To borrow from the brains of Markowitz, in a mean-variance framework this can only be profitable if the writer can predict the range of equity performance better than the rest of the market.

Of course, if risk-aversion is leading punters to overpay for options, the income will compensate here. But, that’s not how it worked out over the past year. Equities aren’t delivering small drops in equity prices they are delivering large corrections. And the rises are just as fierce as the falls. Option overwriting funds offer full participation on the way down and costly opt-outs on the way up.

Winter discounts

Why this option overwriting fund?

Among other things – healthy liquidity, heavy allocation of financials, NASDAQ-listing – this fund has great downside potential as it is closed-ended. The main difference between open-ended and closed-ended funds (or OEICs and investment trusts in the UK) is that closed-ended funds can trade at wide discounts to net asset value. This fund is already trailing its assets by 12%. Popularity is just as important as the fundamental performance of the underlying. The reason we pick this fund is that both are going our way – down.

In the UK closed-end market, most funds trade at a narrow discount, but a few show the possible extent of bearishness.

Vietnamese equity funds trade at 50% asset value, Bulgarian property funds trade worse still, at one-quarter of assets.

I’m not suggesting that might be what awaits Madison/Claymore. Indeed, one of the dangers of shorting closed-end funds is that the managers can buy back their units if the fund becomes, in its view, too discounted. But, it does give investors a further dimension to enjoy short selling gains.

There’s a slightly cruel irony to overwriting funds, vehicles specifically intended for riskaverse individuals, underperforming in a bear market. But this is no ordinary bear market, this is a binary market and we will aim to take advantage in what could be a second good year for the cult of inverse equity.