Ask Mike:
What do you think about the short ETFs?

Question:

Hello Mike,

What do you think of ProShares Short ETFs, including: SH, DOG, PSQ, SDS, DXD, QID?

Thanks,

Tom D from Connecticut

Mike's Response:

Hi Tom,

First, I think it would be a good idea for the rest of our subscribers to clearly understand the concept of a 'short ETF'...

Another term for 'short ETF' is 'inverse ETF'. Inverse ETFs seek to increase in value when the holdings in the Exchange Traded Fund decline and decrease in value. When the holdings rise in price, the value of the ETF goes lower.

Some inverse ETFs are designed to move 1-for-1 meaning if the holdings in the ETF move lower by 1%, the value of the ETF moves upward by 1%. Others are designed to move 2-for-1 or more.

Inverse ETFs can be a great opportunity for investors to take advantage of a declining or bear market, without the need to sell short. In fact, many investors cannot sell short because they are trading out of IRA accounts, which prohibit short selling... not because there is something inherently wrong with short selling, but because if forced to cover a short sale, the IRA account would be required to do a distribution which it cannot do without meeting certain other IRA-specific requirements that might incur a taxable event.

Inverse ETFs are basically shorting the market. But, as an investor, we can buy or take a long position in an inverse ETF, and thereby, be short the market by being long the ETF.

The same rules apply for buying and selling inverse ETFs as any other ETF or stock. You don't have to use margin to buy an inverse ETF. If, on the other hand, you wanted to short an ETF, you would have to use margin to do it... another no-no for IRA-type accounts.

Inverse ETFs give us the opportunity to hedge the market. I fully expect to be buying some inverse ETFs in 2007 as I expect the US markets to potentially decline significantly in the 2nd and 3rd quarters.

I like the inverse ETFs... just not right now. ProShares and Rydex have the bulk of inverse ETFs, but more are coming out I am sure.

When the inverse ETFs came out last year, it gave me the opportunity to discontinue short selling in my Market Trend portfolio. Keep in mind, there is a bear market somewhere, even when the overall market is a bull market. I have all of the inverse ETFs you mention in my database and a lot more.

I track and chart inverse ETFs just like I do regular ETFs and stocks. I have a trend line and buy/sell signals for inverse ETFs just like I do any other tradable security. I am anxious to buy some of the inverse ETFs, but they first have to give me a technical buy signal. At the moment, none of the inverse ETFs are providing a buy signal.

One other significant note on ETFs... Don't begin to think that an ETF has a life unto itself. An ETF will never have a share price that is significantly different from the proportional share price of its holdings. If such a disparity were to exist, big investment firms would convert their ETFs to the holdings or vice versa. There is never an arbitrage opportunity between an ETF and its holdings. This is more than just a technical point... this is a very good thing for us investors. It gives us the opportunity to assess the holdings, from a fundamental perspective, to draw a conclusion on the real value and directional heading of the ETF.

As for the ETFs you mention in your email according to the ProShares website:

SH seeks daily investment results, before fees and expenses, that correspond to the inverse (opposite) of the daily performance of the S&P 500 Index.

DOG seeks daily investment results, before fees and expenses, that correspond to the inverse (opposite) of the daily performance of the Dow Jones Industrial Average Index.

PSQ seeks daily investment results, before fees and expenses, that correspond to the inverse (opposite) of the daily performance of the NASDAQ-100 Index.

SDS seeks daily investment results, before fees and expenses, that correspond to twice (200%) the inverse (opposite) of the daily performance of the S&P 500 Index.

DXD seeks daily investment results, before fees and expenses, that correspond to twice (200%) the inverse (opposite) of the daily performance of the Dow Jones Industrial Average Index.

QID seeks daily investment results, before fees and expenses, that correspond to twice (200%) the inverse (opposite) of the daily performance of the NASDAQ-100 Index.

ProShares has several other ETFS, as well. For now, I will wait until we get a buy signal on them before adding them to one or more of the portfolios.

Regards,

Mike