Should Short ETFs be Banned?
By Ron DeLegge, Editor
March 3, 2009
SAN DIEGO (ETFguide.com) – If Baron Rothschild was still alive, he would probably agree that today’s stock market performance is indicative that “blood is in the streets.”
Most exchange-traded funds (ETFs) and mutual funds that own stocks are reeling, yet a small group of short ETFs that move in the opposite direction of the stock market are surging.
Since the beginning of the year through the March 2nd market close, the Direxion Large Cap Bear 3x Shares (NYSEArca: BGZ) are ahead by 78.0%, the Direxion Developed Markets Bear 3x Shares (NYSEArca: DPK) has advanced by 110.3%, the UltraShort Financial ProShares (NYSEArca: SKF) are up by 93.3%, and the UltraShort Real Estate ProShares (NYSEArca: SRS) have increased by 81.4%.
Still, all of that juicy performance that hasn’t stopped detractors of short ETFs from voicing their suspicion.
In a recent television episode, CNBC’s Jim Cramer challenged the Securities and Exchange Commission (SEC) to ban short ETFs. In the weeks that have followed, Cramer has continued his one-man crusade against short ETFs. Never mind that his stock picks (collectively) haven’t lived up to their hype. (See Barron’s August 18th, 2007 and February 9th, 2009 editions for detailed analysis of his record.)
Should the SEC ban short ETFs from existence?
Investors Vote with their Money
Judging by what ETF investors have been doing with their money, the answer is an affirmative “No.” Over the past 14 months, the S&P 500 (NYSEArca: SPY) is down roughly 60%, the Dow Jones Industrial Average (NYSEArca: DIA) is down more than 55%, and financial stocks (NYSEArca: XLF) have been clobbered more than 95%. As if that wasn’t bad enough, stocks people once viewed as blue chips, like Citigroup (NYSE: C), Bank of America (NYSE: BAC), and General Electric (NYSE: GE) have joined the meltdown. The typical stock mutual fund and hedge fund have not spared their investors either.
With global stock markets in full-blown bear mode, money has been flowing into both leveraged and unleveraged short ETFs. At the end of January, there was $24.05 billion in leveraged and short ETFs managed by ProShares and DirexionShares. Between the two firms, they raked in almost $5 billion in assets in January alone. While these asset numbers may seem large, they’re still a drop in the bucket compared to mutual funds and hedge funds, which together control some $10.6 trillion.
Correcting Perverted Views
Many erroneous viewpoints about leveraged and short ETFs persist. One perverted viewpoint is that short ETFs sidestep securities law which governs short sales. If this were true, the SEC would’ve never allowed already heavily regulated leveraged and short ETFs to come into existence let alone trade on public exchanges.
"We reject the notion that short ETFs harm the markets,” comments Dan O'Neill, President and Chief Investment Officer, Direxion. “Healthy markets are designed to discover the proper price levels for whatever is being traded. Most people recognize that permitting short selling simply adds robustness to price discovery. Those in favor of banning shorts are trying to manage the market higher by silencing one side of the argument. This is generally self-defeating and harmful in anything but the very short term.” O’Neill also observes, “The recent housing bubble - which was caused at least in part because it is not possible to short housing - shows the danger of one-way markets.”
What do the Assets Say?
Before you believe the propaganda of agenda pushers who argue that short ETFs are harmful to the stock market, look at the facts. Fund providers like ProShares, DirexionShares, and Rydex Investments each offer ETFs that play both bull and bear markets, not just bear.
Below are various excerpts from the ETF Profit Strategy Newsletter
On Dec 15, the Dow was at 8,565. It reached 9,088 before tumbling to 7.100.
published on Dec 15, 2008
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Critics who complain that the UltraShort Financial ProShares (NYSEArca: SKF) is exerting downward pressure on financial stocks fail to mention the Ultra Financials Fund (NYSEArca: UYG), a long leveraged financial ETF, has an asset base more than double SKF! Currently, this pair of ProShares financial ETFs is overwhelming net long financial stocks.
O’Neill observes a similar trend at his Boston-based firm, whose ETFs were launched late last year. “Each of the Direxion Shares long and short ETF pairs is, and has been, for the majority of their brief existence, net long.” He adds, “Although we believe it would be perfectly fine and consistent with healthy markets if the pairs were net short, the fact is that they are net long, meaning they’re adding to market demand.”
Are you using Short ETFs the Right Way?
Depending on your unique investment goals, leveraged and short ETFs may or may not be right for you. If you decide to use these specialized ETFs within your investment portfolio it’s important that you use them correctly. Using a hammer to do the job of a chainsaw isn’t very effective. Likewise, if you’ve determined that short ETFs are not a good fit, realize that you still have strategical choices. In our March ETF Profit Strategy Newsletter, we just highlighted several alternative ETF strategies for profiting and hedging during a bear market.
It’s sufficiently clear that more education about leveraged and short ETFs is needed not just among the investing public, but among financial experts. The people that should understand leveraged and short ETFs don’t.
To that end, it would be a huge misstep for the SEC to act against short ETFs. The already overworked SEC faces many immediate and larger issues that need priority – and banning heavily regulated financial products like leveraged and short ETFs is not among them.
Here’s a checklist of what I believe should be among the SEC’s immediate priorities:
Prevent Crime before it Happens
Financial perversion is on the rise. Bernard Madoff’s alleged $50 billion heist and the $8 billion alleged fraud from Stanford Financial are today’s most visible examples. It’s mind-boggling that such colossal theft could’ve been so easily accomplished. That such thievery is even possible is shamefully inspirational to all at-large criminals.
Here’s what we learn from this: The SEC is very good at creating rules and regulations, but unfortunately, they haven’t been good at stopping crime. As it pertains to financial fraud, the agency needs to change its focus from a being a reactionary organization to becoming a preventative one. Start today!
Regulate Hedge Funds
One of the contributing factors to the global financial meltdown has been a lack of financial transparency. No where is this more evident, than with unregulated or lightly regulated investment pools known as hedge funds. It’s no secret that hedge funds don’t have the same strict disclosure requirements as other investment companies. This poses an acute threat to the financial system, as we’re now learning. The existence of toxic investment assets has been exacerbated because nobody has an accurate handle on who owns what. This lack of financial transparency has fueled today’s instability in the global marketplace. Isn’t it time for the SEC to maintain an orderly market by regulating hedge funds?
Instead of managing or hedging risk, hedge funds as a group have been contributing to an increase in financial risk. Hennessee Group, an advisor to hedge fund investors, estimates that 2008 industry-wide assets melted some 39% or by $782 billion. “2008 was the worst year for hedge funds in both redemptions and performance since Hennessee Group Research began recording performance and assets in 1987,” stated Charles Gradante, Co-Founder of Hennessee Group.
As an ex-hedge fund manager, Jim Cramer should do a better job of educating the public about the problems caused by hedge funds. Maybe, misdirecting blame towards short ETFs is Cramer’s way of protecting his colleagues that run unregulated hedge funds.
Break up the Corrupt Rating Agencies
There is considerable evidence that rating agencies colluded with Wall Street’s securities underwriters to inflate the financial ratings of mortgage-backed securities and other financial burritos. This nefarious activity was done in order to sell mortgage backed products that investors probably would’ve otherwise avoided. Despite all of this, corrupt rating agencies have yet to change their crooked way of doing business.
This time it appears that rating agencies are colluding with the U.S. government.
Referring to the latest $30 billion attempt by the government to help faltering AIG (NYSE: AIG) the March 2nd edition of the Wall Street Journal stated, “Major credit rating companies signed off on the latest package, clearing the way for the deal to go forward.” What “deal?” The fact that disgraced credit rating agencies are still wielding this much power, is very worrisome. Those that are fearful of banks being nationalized should start directing their attention to the backroom deals between the U.S. government and America’s credit rating agencies. The latter, in part, contributed greatly to today’s financial crisis.
Shouldn’t the SEC start investigating?
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