Exchange-traded funds (ETFs) are liquid (mostly), plentiful (some might argue too plentiful), fit into most any portfolio, and most are optionable.
Like anything else, the ETF market is still trying to find itself. The rush to open zillions of ETFs covering every minute niche of the market has led to many shutting down. That’s fine. It’s an evolutionary process — survival of the fittest.
One ETF area that has seen tremendous growth is inverse funds.
These ETFs are designed to move opposite the underlying index or sector. Many of these inverse funds are intended to return two or three times the negative performance of the underlying index or sector they track.
For example, the ProShares UltraShort Financials (SKF) “seeks daily investment results, before fees and expenses, that correspond to twice (200%) the inverse (opposite) of the daily performance of the Dow Jones U.S. Financials Index,” according to proshares.com.
I should point out that the key word in the quote above is “seeks,” because SKF and many other inverse funds do not deliver what they say. Apparently, “seek” is not the same as “deliver.”
Look at the table below. I took the five largest ultra (2x) inverse funds by net assets (according to Yahoo Finance) and compared them to their ETF or index counterparts. Thus, SKF is compared to the iShares Dow Jones U.S. Financial ETF (IYF), a fund that tracks the Dow Jones Financial Index.
I looked at returns for 2008 and 2009 though March 17. I also included a theoretical double-inverse return based on the primary ETF/index.
Note that all inverse ETFs fall short of the mark, although the ProShares UltraShort 20+ Year Treasury (TBT) comes pretty close to its theoretical value.
The biggest disappointments were the financial and real estate shorts, which failed miserably to deliver. In fact, it’s hard to fathom how the ProShares UltraShort Real Estate (SRS) underperformed the iShares Dow Jones U.S. Real Estate ETF (IYR) in 2008 (2009 is looking much better, though).
Those who played the short financials card in 2008 using SKF are no doubt livid about their 3.1% return while the financial sector cratered. Like SRS, SKF is putting on a better show in 2009.
Why the huge discrepancy between what these inverse funds are “seeking” and their actual returns?
The most common explanation is that these ultra-short funds are derivatives that suffer during high-volatility periods.
Whatever the reason, the takeaway message is don’t trust the name of a fund. Don’t assume two- or three-times leverage just because that’s what the prospectus says. Check out the fund’s returns over various periods. “Seeking” and “delivering” are two distinct concepts.
Don’t let this scare you away from ETFs, though. (See also 10 Reasons to Use ETFs When Trading Options.)
Just know what you’re buying.
Jon Lewis is the co-editor of The Winning Edge trading service designed to help you make options profits around corporate earnings and other market events. For more information about Chris, read his bio here.
