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The Market's Recent Near-Death Is Hindering the Use of Inverse and Enhanced ETFs

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Knowing how powerful these ETFs are might make you want to use them, not use them, or use them sparingly.

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As an example, if you are long term, but think the market is going down for a while, what are your options? You can sell your positions -- but suppose you don't want to sell because of tax consequences. You worked hard to construct a portfolio that you like, and think the positions will come back after a market decline. You could buy one or more inverse ETFs. You could buy inverse ETFs to short a fraction of your portfolio as a hedge, perhaps 5, 10, or 20%. You could also choose which asset classes to short, including sectors. With sectors, you would short those that you think will decline the most, and not short the sectors you think might advance or not go down much.

As an example, you could short the small-cap asset class by buying the ProShares Russell 2000 Short (RWM). Or if you prefer a broad-based market short exposure, you could buy the ProShares Short S&P 500 (SH). For enhanced short exposure, you could short the Russell 2000 that seeks a two times daily performance (TWM), or the Derexion Russell 2000 that seeks a three times daily performance ETF (TZA).

There are also inverse exchange traded products (or ETPs) that attempt to achieve performance results over a period of time longer than a one-day trading session. For instance, PowerShares and Deutsche Bank offer ETNs that seek to deliver results equal to 100% of indexes comprised of commodity futures over a one-month period. The goal is to have performances affected by the impact of day-to-day volatility, and not erode or enhance returns as they will with daily-reset ETNs.

With monthly inverse ETNs, the target multiple advances (or erodes), either one time with regular ETNs or in multiples such as two times or three times with enhanced ETNs, but any multiple will apply only at the start of the month. Therefore, investors who buy in the middle of the month could achieve greater (or less) leverage for the remainder of the month than if they bought at the beginning of the month.

Using enhanced ETFs, you can go long or short and use less cash because of the compounding effect. If you are right, you can get better results than if you used non-enhanced ETFs. If you are wrong, your results will be worse using enhanced ETFs because the compounding effect will work against you.

Knowing how powerful these ETFs are might make you want to use them, not use them, or use them sparingly. You really have to know your risk appetite. But knowing how much risk you can stomach is something you always have to consider no matter what you invest in.
The author's clients own TZA.
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