Saturday, July 15, 2006

Another look at the ProShares inverse ETFs

In March I reviewed a number of bear market funds. At the time the only funds available were open ended mutual funds (OEFs), with the most selection from ProFunds and Rydex. In the last couple of weeks, inverse ETFs from ProFunds under the name ProShares started trading and the inverse Q’s (PSQ) has already become quite popular.

The table below compares OEFs with the ETFs. The ETFs enjoy an obvious advantage in the form of lower expenses. Considering also the fact you can trade the ETFs intraday, they should quickly grab market share away from the OEFs.

ProFunds and ProShares Inverse Funds (data from Yahoo Finance/ProShares 7-15-2006)
Fund NameSymbolTarget IndexLeverageExpense Ratio
ProFunds Bear InvBRPIXS&P 5001X1.51%
ProFunds Short OTC InvSOPIXNasdaq 1001X 1.52%
ProFunds Short Small Cap InvSHPIXRussell 2000 1X1.51%
ProFunds Ultrabear InvURPIXS&P 5002X 1.43%
ProFunds Ultrashort Dow 30 InvUWPIXDow Industrials2X1.65%
ProFunds Ultrashort Mid Cap InvUIPIXS&P Mid Cap 4002X1.68%
ProFunds Ultrashort OTC InvUSPIXNasdaq 1002X1.41%
ProFunds Ultrashort Small Cap InvUCPIXRussell 20002X1.43%
ProShares Short QQQPSQNasdaq 1001X 0.95%
ProShares Short S&P 500SHS&P 5001X 0.95%
ProShares Short Dow30DOGDow Industrials1X0.95%
ProShares Short MidCap400MYYS&P Mid Cap 4001X0.95%
ProShares Ultrashort QQQQIDNasdaq 1002X 0.95%
ProShares Ultrashort S&P 500SDSS&P 5002X 0.95%
ProShares Ultrashort Dow30DXDDow Industrials2X0.95%
ProShares Ultrashort MidCap400MZZS&P Mid Cap 400 2X0.95%
Leverage of 1X means the fund aims to produce the inverse daily performance of the target index each day; 2X means twice the inverse daily performance.

Barry Ritholtz at the Big Picture which I read every day traded these inverse ETFs recently and came away with the impression (links here and here): “A good product for hedging in accounts that either cannot short or use options; they are also superior to mutual funds, but inferior to shorting traditional ETFs.” I agree these products are well suited to IRAs and such; moreover, I think they benefit investors interested in a long-term directional bet or portfolio hedging as well.

There are two problems with shorting in general: 1) the potential for loss is unlimited, and 2) as the security drops in price, so is the size of your position, such that the same percentage drops no longer provide the same upside. Let me illustrate these with two idealized scenarios (assuming no commission, spread and perfectly efficient index tracking):

  1. The NDX (Nasdaq 100) starts at 1500. There are 10 consecutive days of 1% declines. At the end of 10 days, the NDX is at 1500 * 0.99 ^10 = 1356.57 and the short from 1500 has gained 9.56%. Meanwhile, PSQ which aims to reproduce the inverse daily movements has gained 1.01^10 -1 = 10.46%, 0.9% better than the straight short. This is because as the NDX declines, PSQ increases in value, thus increasing the size of the position.
  2. If instead the NDX increases 1% per day for 10 days, it would have ended at 1656.93. The short would have lost 10.46% and PSQ only 9.56%. Here the compounding effect goes into reverse. One can never lose more than the principle on the inverse ETFs.

Of course the expense, tracking error and larger spread on the inverse ETFs are real, such that the compounding effect will only be visible after a period of time (probably at least weeks if not months) in a trending market. The other caveat is that in a flat market, the short will break even but the inverse ETF will bleed expenses continuously.

In conclusion, these products cannot replace simple shorts for nimble professional traders, but for everyone else placing a directional bet or a long term hedge, they have merits.

I currently own UCPIX and USPIX (leveraged short OEFs on the small caps and Naz 100). At first I was disappointed that ProShares didn’t offer a small cap based product which I expect to underperform the general market as discussed in my recent piece on rebalancing. Upon closer inspection of the equivalent fund targeting the mid caps (UIPIX), I found their returns, although lagging the inverse Naz 100, have been tracking each other closely:

Going forward, I will consider exiting my OEFs and entering the ETFs especially as part of the move to time the secondary bounces in this decline.