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


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

MINYANVILLE ORIGINAL I worked at Lehman Brothers. Like many people, I thought the firm was omnipotent, and that it might get into trouble, but that it would never die. When the firm collapsed, I was in shock, along with most of the financial world. That shock can be felt to this day. Although it has not made cowards of us all, it has contributed to reducing people's risk appetite. Lower institutional volume coupled with individual investors shunning the market in droves show that risk aversion continues.

In the Lehman collapse and other near-death experiences (such as the Bear Stearns bankruptcy and the freeze-up of the auction rate securities market), there was a realization that the financial system could actually shut down. No generation of investors has seen this since the market crash in 1929. Not only did stock and bond investors get hurt, but those who had "safe" fixed-income investments that paid a little more than money-market funds got hurt as well. Investors were surprised to see that they had been taking on a lot greater risk than they had thought.

Because of the shock, you hear things such as, "Stay away from anything having to do with derivatives, leverage, inverse, and margin." This has kept some investors from using some effective investing and trading tools, tools that can lower risk, increase profit, and otherwise change the complexion of portfolios and fine-tune investment strategies.

Using Leveraged and Inverse ETFs.

Inverse and leveraged ETFs are effective tools for traders and investors. These securities can also cause great harm if not used the right way, so it is important that investors understand what these ETFs are structured to do.

With the backdrop of the Lehman Brothers meltdown and the fear that something like that could happen again, we also are exposed to the widely publicized bad experiences of traders and investors who did not totally understand inverse and leveraged ETFs. This has added to the aversion to using them. There are also other securities that are subject to risk aversion caused by misunderstanding, such as leveraged closed-end funds, both taxable and tax-free, structured market-linked CDs, commodity exchange traded notes (or ETNs), and others.

Adding to the confusion is that things that sound like ETFs are not ETFs, such as ETNs. ETNs are different than ETFs. One of the major differences is that holders of ETNs usually have credit risk. This means that if the ETN maker, which is usually a major bank or other financial institution, goes broke, the ETN holder could lose all or part of his or her investment. Because of their structure, regular ETFs hold the actual securities of the indexes they are replicating, whereas ETNs usually hold futures and derivatives, and are structured to return the performance of a commodity or benchmark, not replicate an index, as an ETF is constructed to do.

Risks and Rewards.

For those who take the time to understand the nuances of how inverse and enhanced ETFs work, the securities can be powerful tools to use for hedging as well as speculating on market long-term and short-term moves. Long-term investors with a buy-and-hold strategy would use these securities differently than a trader. A long-term investor using them should have a clear purpose in mind, and have a time horizon to be long the securities and then sell them.

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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