Inverse Etfs

A funny thing happened on the way down from the NASDAQ 5,500 from 2000 until early 2007; it's still only nearly half that previous high level. During the period of significant decline from 2000-2003 investors who shorted near the top made as much money on the way down, and with greater velocity, as those did on the way up. The ETF Digest for example made between 30 percent-70 percent per year just being short during that period.

One of the promoted benefits of ETFs is the ability to short them and do so without an uptick.* Unfortunately for many retail investors, being able to short available ETFs was nearly impossible for those beneath the top 10 or so in trading volume.

Why?

First, in order to short, your broker must be carrying inventory of those shares, either as a house position, or in the margin accounts of their customers, in order to lend them to you for shorting. It's expensive for

*The rule dating from the 1929 market crash designed to prevent momentum driven shorting. ETFs were exempt from this rule, but soon many stocks will too be given recent SEC proposals and comments.

firms to carry inventory although profitable for them to lend given potential margin income from charges. If you're working with an online discount broker and you entered an order to short a "difficult to short'' [the common phrase describing this often futile effort] the order would no doubt be rejected, whether a market order or not, with a "no stock available'' advice. You could reenter the order until hell froze over, but you're still going to get the same advice. Now some wire-house firms like to suggest that they'll "work the order'' for you and find stock. This is nonsense to me, having gone through this experience myself. If as an FA at a major wire-house you try to accomplish this you'll only get the same answer.

Do the major firms have the capability of finding stock for you? Sure. Will they? Probably not, either when you want them to execute the transaction or if at all. Let me tell you, I've made many a call to margin clerks with a big firm and they're not going to go out of their way to find your retail client a few hundred shares. It's just not going to happen since you may as well be dealing with the post office bureaucracy.

One online firm, ETrade [and there may be others not polled by me] has stated that if you call them, they will try to find you stock to fill your order. They say it's done routinely by them but I haven't put them to the test.

There are other issues with hard to short ETFs. Stock specialists are a part of the process in accommodating retail short requests. Sometimes they're just not interested in finding stock from their order book to provide to the brokers. Further some ETFs are connected to more obscure indexes where there are no futures contracts or other vehicles for the specialist to offset their short position risk.

Finally, as we pointed out previously there are creation units that Nate Most came upon. Investors can go to the trustee of the fund and have more shares issued. The sponsors love this since more shares issued means more fee income. However, most creation units are either in 50 thousand to 100 thousand share counts. How many retail or even "mass affluent'' investors have that kind of financial capacity? Not many obviously.

Therefore the promoted benefit is not being realized thoroughly by retail investors. When we presented this problem repeatedly to exchanges and sponsors they pointed to the brokers as the problems. So did the specialists. And so the buck-passing continued. In fact the exchanges just suggested that retail investors finding difficulty shorting should just turn to the options market. In my opinion, most options strategies available were never satisfactory and here I speak as an options principal. Besides options strategies were more lucrative financially to the exchange than if they had to work at helping fulfill the promoted shorting benefit.

Finally, for the burgeoning IRA and 401[k] market, not to mention other tax-exempt entities, shorting is restricted. Therefore, if you wanted to hedge your portfolio or speculate using ETFs you couldn't do it. As we outlined in chapter 1 the rollover IRA is going to be a huge market as Baby Boomers retire and receive their lump sum from their employers. They'll want tools to protect their portfolios.

The solution to this problem was the "inverse" ETF, which simply stated allow you to be short by going long. Say again? If you're not allowed to short in the aforementioned restricted accounts, then you could just buy an inverse issue, which benefits if prices related to the associated index decline. Pioneering this strategy was ProShares, an affiliated ETF sponsor to mutual fund provider ProFunds Advisors LLC. ProFunds had already had a lengthy experience at dealing with inverse issues in conventional mutual fund structures. The attraction of doing the same thing within an ETF structure was too good for them to pass up so they filed for some inverse issues with the SEC.

Approximately eight years passed while the SEC sat on their registration filing. Nothing moved in the bureaucratic process and because of the mandated quiet period, ProShares spokespersons couldn't talk about it. A pretty frustrating experience for all concerned including the ETF Digest since we were anxious to have the tools available. But finally in June 2006, the first batch of inverse ETF issues hit the Street.

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