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Beating the Bear Without Using Short ETFs

Beating the Bear Without Using Short ETFs
By Ron DeLegge, Editor
February 18, 2009

SAN DIEGO ( Ė Some of the most popular ETFs over the past 52-weeks are leveraged and short ETFs. We know this because net cash flows tell us where investorís money is flowing to. In January alone, roughly $5 billion was put into leveraged and short ETFs. 

In a very short period of time, the ProShares have amassed $22.6 billion under management. After just three months of launching short ETFs, upstart Direxion Shares already has around $1.5 billion. Some of this asset growth is attributable to market performance but another driving factor has been investors pouring money into these high specialized funds. Do investors really understand what theyíre getting?

In 2006, the first iteration of leveraged and short ETFs was introduced. Leveraged ETFs attempt to magnify their performance by twice (200%) or three (300%) times the daily performance of their underlying indexes. Short ETFs aim to deliver opposite or inverse performance of their benchmarks. If a stock benchmark declines in value, a short ETF is supposed to increase in value. The same mechanics apply in reverse.

Below is an excerpt from the ETF Profit Strategy Newsletter Ė Published on Dec 15, 2008
At the time, the Dow was at 8,565. It reached 9,088 before dropping below 8,000.

Market Meter

Short-Term: published on Dec 15, 2008
The Dow should claw its way towards 9,150
Mid-Term: published on Dec 15 2008
Extreme optimism above Dow 9,000 will draw the Dow towards 7,445
Alert on Jan 6: Sell signal! "Dow at 9,000 might be the high for 2009"
Long-Term: >> Sign up to find out

How did you do? >> Sign up for the ETF Profit Strategy Newsletter to be a step ahead

While many investors have a rough idea what leveraged and short ETFs are supposed to do, even fewer have a clear handle on the other important details. Maybe thatís the reason why so many investors that own short ETFs are surprised by their fundís performance. Tracking error, index volatility, larger than life tax liabilities, and elevated expense ratios are all counterproductive activities that complicate both the execution and net performance of leveraged and short ETFs.

Before we consider alternative solutions to short ETFs, letís examine some text book examples of short ETFs gone bad.

ProShares UltraShort FTSE/Xinhau China 25 (NYSEArca: FXP)
The idea behind FXP is to deliver twice (200%) the inverse or opposite daily performance of the FTSE/Xinhua China 25 Index. The index consists of the 25 largest and most liquid Chinese companies. All index components trade on the Hong Kong Stock Exchange.

The iShares FTSE/Xinhau China 25 (NYSEArca: FXI) declined by 49.88% in 2008. An even broader measure of Chinese stocks, the SPDR S&P China ETF (NYSEArca: GXC) recorded around the same lackluster results, dropping 50.68%. Curiously, FXP declined by 53.52% in 2008 which was worse than both FXI and GXC. While the daily performance of FXP may have closely matched its investment objective, investors that held FXP for the year were badly disappointed. 

ProShares UltraShort Financials (NYSEArca: SKF)
In 2008, SKF eked out a gain of just 4.28% in a year when S&P financial stocks (NYSEArca: XLF) cratered by 55.21%. On the surface, a short ETF investor may have calculated their theoretical gains should have been closer to 110%. But not so! SKFís 2008 performance was complicated by many factors including record index volatility and the SECís temporary short selling ban on financial stocks.

Rydex Inverse 2X S&P Select Sector Energy (NYSEArca: REC)
This ETF is designed to short S&P energy stocks by two times their daily performance. In 2008 S&P energy stocks (NYSEArca: XLE) dropped by 38.79%. Unfortunately, short energy ETFs were not a haven of safety, especially from taxes.

Investors that were unfortunate enough to still own REC at the close of trading on December 9th of last year were hammered with an 86.61% short term capital gain. This gigantic tax distribution was immediately reflected in RECís share price because on the very next day the fundís share price traded around $12.60 from its previous day of just over $100 per share! Who wouldíve thought that a six-month year old fund would distribute such a mammoth tax gain! REC is a classic example of the sort of nightmare scenario that leveraged and short ETFs can cause for investors. If tracking error and index slippage doesnít get them, it might be a nasty tax surprise.

Alternatives to Short ETFs
Given the fact that short ETFs donít necessarily execute what investors want, what are the alternatives? In our March edition of the ETF Profit Strategies newsletter we highlighted one alternative investment strategy that uses ETF options to profit during a declining market. By owning put options, an ETF investor can in many cases more accurately hedge their portfolio when the market falls. If youíre going to succeed during these challenging market conditions, itís essential that you use the right financial tools and methods to achieve your financial goals.

Before using options itís advisable that you obtain the required education from trusted sources like Yahoo Finance. You will also need to get authorization from your broker before executing any ETF option trades. Yahoo Finance lists the call/put options for ETFs and also publishes a call/put option list on the entire universe of exchange-traded products.

In summary, donít let anyone tell you otherwise: You can still be a bear without using short ETFs.


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