The Wall Street Journal-20080123-Hedging Your Bets- Check Bearish ETFs- Strong-Performing Funds Match Inverse of Indexes- Watching Out for Risks
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Hedging Your Bets? Check Bearish ETFs; Strong-Performing Funds Match Inverse of Indexes; Watching Out for Risks
With stock-market indexes from Hong Kong to Frankfurt to New York lit up in walls of red, some exchange-traded funds are standing out as tantalizing corners of green.
The 25 best-performing exchange-traded funds in the young year have all had total returns of more than 19%, contrasting with a year-to- date decline in the Standard & Poor's 500-stock index of 9.7% through Friday. What they all have in common is they aim to provide returns that match the inverse of common investing benchmarks like the S&P 500 or the Russell 2000.
That means, theoretically, if the S&P 500 falls 1% on a given day, the S&P inverse fund would rise 1%. Many of the best-performing ETFs actually take it a step further, aiming to magnify investors' returns, rising, say 2% on a day the benchmark falls 1%.
While these bearish funds may look appealing, individual investors need to tread carefully. Funds that magnify returns can be far more volatile than other investments. The funds' unusual investment aims can also be tricky to understand: While these funds magnify bearish returns by two times over the course of a single day, the effects of compounding on their daily performance means that isn't always the case over longer periods.
And though these funds remain mainly the domain of hedge funds and institutional traders, many believe they are starting to catch on with financial advisers. "You can use them to hedge your long positions," says Tom Lydon, president of Global Trends Investments, a registered investment adviser in Newport Beach, Calif. In small doses, bearish ETFs can help quickly neutralize sagging stock returns, he says.
Among the biggest winners so far this year: UltraShort Semiconductor ProShares ETF, up 51.6% through Friday, and UltraShort Financials ProShares ETF up 29.8%, according to Morningstar. Both funds offer double inverse returns of their benchmarks.
The risk and extra complexity has made some ETF experts critics. "I'm not a big proponent," says Morgan Stanley ETF analyst Paul Mazzilli, who publishes research on ETFs to help Morgan's brokers. "I don't recommend them."
While Morgan Stanley doesn't prevent its advisers from buying the funds, and some do, Mr. Mazzilli says he fears the funds could be used for "timing" segments of the market, or trying to guess short-term stock movements.
An incorrect bet can prompt big losses. While bearish ETFs have provided some of the best returns of the year, similar funds that offer to double benchmark returns on the bullish side have provided some of the worst returns.
The biggest loser in 2008, according to Morningstar: Ultra Semiconductor ProShares ETF, down 37% through Friday, sister of the top-performing ultrashort fund.
Proponents of the funds insist they can be used wisely.
J.D. Steinhilber, president of AgileInvesting, a registered investment adviser in Nashville, Tenn., bought the UltraShort Russell 2000 ProShares ETF, a bearish fund that targets small-company stocks, last spring. He was worried a U.S. recession could hurt the stock market, and that small companies would fare worse than larger companies.
Most of his clients' stock investments were in international and large-company stocks. Buying the bearish fund allowed him to hedge some of the risk that stocks would fall without actually having to sell any holdings, possibly prompting a taxable capital gain for clients. At the same time, the move allowed him to bet on his opinion that small companies would be the ones hurt the most. Mr. Steinhilber says he sold the investment late this past summer at a profit.
