Exchange-traded funds have taken the investing world by storm,
and one of the reasons why ETFs have grown so popular is that you
can get just about any kind of focused exposure to specific
market niches that you want. But one type of ETF in particular
has gotten a lot of attention because of its ability to let you
make large bets against certain types of investments. Known as
ultrashort ETFs, these exchange-traded funds use a combination of
leverage and derivatives to produce positive returns when their
target benchmark falls in value. But before you invest in an
ultrashort ETF, it's important to know how they work and what
risks they carry.
What are ultrashort ETFs?
An ultrashort ETF is an exchange-traded fund that holds assets
whose value goes up when the fund's targeted asset-class
benchmark goes down. For instance, an ultrashort ETF that targets
the S&P 500 might be set up so that its value will rise by 2%
or 3% if the S&P 500 declines by 1% on a given day.
Conversely, if the S&P 500
, then ultrashort ETF shareholders suffer magnified losses on
Even industry giant ProShares acknowledges the risks
involved with inverse leveraged funds. Image source:
The most important thing to understand about most ultrashort
ETFs is that they're designed to track the
performance of a given benchmark index. That doesn't always
translate into long-term performance that matches what you'd
expect based on a fund's name. So, for instance, a two-times
ultrashort ETF might rise 2% when the market falls 1%. But if the
market falls 10% over the course of a
, there's no guarantee that the ultrashort ETF will rise 20% --
and, depending on the fluctuations in market prices, an
ultrashort ETF can even
money in a down market.
What is the history of ultrashort ETFs?
The ultrashort ETF is a relatively new phenomenon, having
first become available in the mid-2000s. That means ultrashort
ETFs were available to investors seeking to take advantage of the
financial crisis and market meltdown of 2008, which saw the value
of many ultrashort ETFs targeting the stock market soar in
response to the crash in stocks.
Since then, though, ultrashort ETFs have performed abominably,
with strong and steady advances in stock markets causing
disastrous losses for those betting against the market. For
ProShares UltraShort S&P 500 ETF
has lost 85% of its value over the past five years, and investor
interest has lagged accordingly: The fund's assets under
management have dropped from $4.7 billion in mid-2009 to just
$1.6 billion today.
Ultrashort ETF Total Return Price
How many ultrashort ETFs are there?
You can find dozens of different exchange-traded funds that
offer leveraged inverse exposure to given markets. Some
ultrashort ETFs focus on popular stock indexes like the Dow Jones
Industrial Average and the S&P 500, while others are designed
to track specific sectors of the stock market or certain niches
of other asset classes such as bonds and commodities. In
addition, some companies specialize in double-inverse ultrashort
ETFs, while others go the extra mile to seek out triple-inverse
returns for their shareholders.
The largest ultrashort ETF is the
ProShares UltraShort 20+ Year Treasury ETF
, which had about $4.4 billion in assets under management as of
early August. The ETF is designed to rise in value if bond prices
fall, which would correspond to a much-anticipated rise in
interest rates that many see as an inevitable consequence of the
Federal Reserve's recent actions to curtail quantitative easing
and return the bond market to more normal conditions.
Why invest in ultrashort ETFs?
The idea of trying to make money when certain assets decline
in value is a reasonable goal for investors. The problem, though,
is that the leveraged bet made by ultrashort ETFs adds a
short-term component to the investing strategy, and that makes
them unsuitable long-term investments in most cases.
Ultrashort ETFs can make big gains if the market falls quickly,
but they don't always work in the long run.
Specifically, the danger with ultrashort ETFs is that
volatility in the underlying benchmark can erode the value of the
ETF even if the benchmark itself remains almost unchanged. The
reason has to do with the mechanisms that an ultrashort ETF uses
to track those daily changes. If the underlying benchmark rises
and falls on certain days but ends up in the same place over
multiple days, then ultrashort ETFs will lose value even as the
underlying benchmark remains flat. In some cases during the
financial crisis, that led ultrashort ETFs to lose value even
when their corresponding benchmarks
over the course of a few months.
As a short-term bet on a particular market falling, owning
shares of an ultrashort ETF can be your most aggressive way to
profit if your suspicions prove correct. But many investors have
been surprised at how quickly these funds' returns can erode in
comparison to the markets they're supposed to track. Keeping that
in mind can help you prevent your ultrashort ETF position from
turning into a disaster.
More from The Motley Fool:
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Ultrashort ETF: Investing Essentials
originally appeared on Fool.com.
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