Recently a member of Pat McKeough’s Inner Circle asked about exchange-traded funds (ETFs) that are “set up to move in the opposite direction of particular stock indexes”. These are ETFs that are designed to rise in value as the underlying market index falls: if the index falls by 1%, the shares of the ETF should rise by 1% and so on. Known as “short ETFs” or “bear market ETFs” they may appeal to some investors during volatile markets. Using the example of U.S.-based firm Pro Shares, Pat explains how these ETFs work. Then he explains why we believe that short ETFs are unsuitable for most investors.

U.S.-based ProShares offers a range of exchange traded funds for U.S. stock indexes. The company offers two types of ETFs that are designed to “short” the market:

1) ProShares Short ETFs are designed to move in the opposite direction of the underlying index. For example, ProShares Short S&P500 (symbol SH on New York) aims to move in the opposite direction of the daily performance of the S&P 500 Index. This ETF has a 0.90% MER.

If the S&P 500 Index is down 2% on a particular day, the Short S&P500 ETF should be up about 2%. If the S&P 500 Index rises 2%, the Short S&P500 ETF should fall 2%.

ProShares also has short market index ETFs for the Nasdaq 100, the S&P 400 MidCap Index and the Dow Jones Industrial Average.

2) ProShares also offers UltraShort ETF versions of the same market indexes. Using borrowing and/or derivatives, these UltraShort ETFs are supposed to move twice as far in the opposite direction as the market indexes.

For example, ProShares UltraShort S&P500 (symbol SDS on New York) aims to move 200% in the opposite direction of the daily performance of the S&P 500 Index. This ETF has a 0.91% MER.

If the S&P 500 Index is down 2% on a particular day, the ProShares UltraShort S&P500 should be up about 4%. If the S&P Index 500 rises 2%, the ProShares UltraShort S&P500 should fall 4%.

ProShares also has UltraShort market ETFs for Nasdaq 100, the S&P 400 MidCap Index and the Dow Jones Industrial Average.

ETFs: Investors absorb extra costs in addition to the MER

As a general rule, we advise against short selling, much as we advise against options trading, leverage, currency speculation and bond trading. In all of these activities, it’s a rare investor who makes enough profit to compensate for the risk involved. Our view is that if you like the outlook for a market index, you should invest in stocks that will profit from a rise in that index.

Institutional investors, particularly hedge funds, carry out around 60% of all trading in leveraged and inverse-leveraged investments. They generally use them as part of complicated multi-investment trading gambits. They also trade frequently, and in large quantities. This reduces the percentage costs of this kind of trading. However, the trading costs still tend to eat up the invested capital.

One added concern is counterparty risk. That’s the chance the other party in a contract to repurchase securities will default on their obligations. Counterparty risk increases during times of extreme market volatility.

ProShares plans to enter into repurchase agreements only with large, well-capitalized and well-established financial institutions. But the cost of eliminating counterparty risk is going to cut into the potential profit you earn by investing in ProShares. So will any losses you incur due to timing errors—buying the Short or UltraShort series prior to a market rise or buying the Ultra market series prior to a market downturn.

Inevitably, investments like these will go down more readily than they go up. That’s because investors have to absorb the costs of borrowing, entering into agreements with counterparties and so on, on top of the MERs.

We advise against investing in any of these ETFs.

TSI Network recommendation: SELL

For our look at the features and practices of different types of investment funds and how they affect you as an investor, read What are the risks and rewards of securities lending?