How to Use Inverse Exchange Traded Funds on Marketwatch

ETF INVESTING

Short plays only

Holding leveraged and inverse ETFs too long distorts objectives

By John Spence, MarketWatch

Last update: 3:32 p.m. EST Jan. 18, 2009BOSTON (MarketWatch) -- The market rout in 2008 has exposed the dangers of leveraged and leveraged inverse exchange-traded funds, designed to capture two or three times the movement in a particular stock index or provide 100% opposite results, as investors learned the hard way about the tax and performance distortions inherent in the funds.
These relatively new financial products are "among the fastest growing segments of the U.S.-listed ETF market" with $21.6 billion in assets and $17.4 billion in average daily trading volume, Morgan Stanley analysts led by Dominic Maister wrote in a research note last week.



Leveraged and inverse ETFs are "appropriate tools for some investors looking to make short-term tactical trades if they perceive a high likelihood of a strong market move occurring in a relatively short time period," said Maister.
In other words, traders and speculators can get more bang for their buck if they're trying to exploit quick market swings. Of course, losses are also magnified when markets move against the trade.
However, the effects of compounding "and the daily re-levering or de-levering that occurs within leveraged and leveraged inverse ETFs can lead to unexpected results over the long-term," Maister said. Investors probably don't want to hold leveraged and inverse ETFs more than a few days, experts warn.
The key point is that these ETFs provide leverage on a daily basis. Simply, investors are mistaken if they think they can buy a twice-leveraged ETF, hold it for a year, and end up with double the market's return.
"We cannot stress enough that these aggressively leveraged products are not suitable as long-term investments," said John Gabriel, ETF analyst at Morningstar.
Understanding performance
Market volatility can also play havoc with performance over longer periods. Some analysts have seized on the performance of leveraged ETFs tracking energy stocks during a wild 2008. The sector rose early in the year but corrected hard during the back half.
ProShares Ultra Oil & Gas ( ProShares Ultra Oil
DIG) lost 72% in 2008, according to ProShares. The bearish leveraged version, ProShares UltraShort Oil & Gas ( DUG) , also lost money last year, shedding nearly 11%. Yet on a daily basis, the ETFs delivered their targeted leverage like clockwork, so they behaved exactly as they should have.
In fairness, the providers of leveraged and inverse ETFs are upfront about the performance issues over the long term on their Web sites and in the prospectus.
"A common misconception is that ProShares should also provide 200%, -200% or -100% of index performance over longer periods, such as a week, month or year," ProShares says on its site. "However, ProShares' returns may be greater than -- or less than -- what you'd expect over longer periods." See the document at ProShares.com.
Therefore, if investors do stay in leveraged funds for any extended period of time, they should consider rebalancing frequently and keep a close eye on performance.
ProShares Chief Executive Michael Sapir said the firm wants all its investors to understand the math of compounding returns and how it affects its leveraged financial products.
"We think we've done a good job in trying to disclose the information," Sapir said in an interview. "We welcome every opportunity to get the word out."

ETFs on steroids

ProShares is one of a trio of investment managers overseeing leveraged and inverse ETFs that also includes Rydex Investments and Direxion Funds.
Leveraged ETFs managed by ProShares and Rydex are designed to provide 200% of the daily performance of their targeted indexes. Their inverse ETFs shoot for 100% of the inverse, or opposite, daily return, so they can be used to bet against markets or hedge.
Leveraged inverse ETFs aim for negative 200% returns on a daily basis. So if the target benchmark fell 2% in a trading session, these leveraged inverse ETFs are geared to rise about 4%, minus fees and transaction costs.
More recently, Direxion Funds has launched ETFs to provide even more leverage, at 300%, of daily index returns in both directions. The funds have gotten off to a strong start in terms of attracting assets and trading volume.
Some traders like juiced-up ETFs because the funds allow them to get leveraged exposure to the market or individual sectors in liquid vehicles that can be bought and sold during the day. Investors don't have to open up a margin account to tap leverage.
Meanwhile, inverse ETFs let investors profit from market declines or hedge their long positions.

Why taxes work differently from 'vanilla' ETFs

The tax efficiency associated with plain-vanilla ETFs that track stock indexes is a result of the specialized way in which shares are created and redeemed. Although the "in-kind" creation and redemption process is complex, these stock ETFs can protect against the potential tax hits often seen in mutual funds when managers are forced to sell stock and raise cash to meet shareholder redemptions.
However, leveraged and inverse ETFs keep their assets in a pool of cash and use swaps and derivatives to deliver performance -- a key difference.
"If the fund goes into net redemptions and starts to shrink in assets, the managers must sell some of the derivatives they used to replicate their benchmark instead of passing them off to the authorized participants," wrote Morningstar's Gabriel in a recent report.
Authorized participants are institutional traders responsible for keeping orderly markets in ETFs by creating and redeeming shares based on demand.
Leveraged funds typically use daily swaps to gain their exposure, and these contracts are always settled in the short term, added Paul Justice, an ETF strategist at Morningstar.
"Most of the ETF assets are held in Treasury accounts, but the leveraged performance is generated by using short-term swaps and futures contracts. Those funds that performed well accumulated large capital gains when the funds spiked in October," he said.
"But when many shareholders liquidated their positions, those taxable gains were later split amongst fewer shareholders," Justice said. "Unfortunately, some investors that hung on too long are in for an unpleasant tax surprise."
In late December, for instance, ProShares announced capital gains distributions for 35 of its 76 leveraged and inverse ETFs. At Rydex, the Rydex Inverse 2X S&P Select Sector Energy ETF ( REC) paid out capital gains of more than 70% of net asset value, according to investment researcher Morningstar Inc. Those gains caught some investors off guard. Read more on this ETF surprise at WSJ.com.
However, the analysts said the distributions aren't grounds to avoid short and leveraged ETFs, just a reason for caution.
"These funds still have the trading advantages of liquidity, timeliness, and low commissions just like every other ETF. They still provide hedging and speculative opportunities that are otherwise inaccessible to the individual investor," Gabriel said. "They do not possess the impressive tax advantages of most ETFs, but they should still perform no worse than a similarly structured traditional open-end mutual fund on this point."
The old saw merits repeating here -- investors should always consult with a tax adviser.
John Spence is a reporter for MarketWatch in Boston.