Short ETFs have been the best performing asset class ever since the market meltdown started in October 2007. Many short ETFs gained 100% or more and singlehandedly transformed a disastrous market into a profitable one.

Nevertheless, there are pitfalls investors need to be aware of. Otherwise unwanted side effects could leave you with all the sizzle and none of the steak.

The basics

Short ETFs intend to replicate 1x, 2x or 3x the daily inverse performance of the underlying index. Leveraged (long) ETFs intend to deliver 2x or 3x the daily performance of the underlying index. The leveraged component magnifies the performance of the underlying index while the short component delivers the opposite or inverse performance of the index.

Example: (leveraged) short ETFs

To illustrate, let's take a look at a suite of short or inverse ETFs linked to the S&P 500 Index (NYSEArca: SPY). The Short S&P 500 ProShares (NYSEArca: SH) aim to deliver the opposite daily performance of the S&P 500, the UltraShort S&P 500 ProShares (NYSEArca: SDS)  aim to deliver twice the opposite daily performance of the S&P 500 while the Direxion Large Cap Bear 3x Shares (NYSEArca: BGZ) aim to deliver triple the opposite daily performance. A 1% loss in the S&P 500 would (ideally) translate into a 1% gain for SH, a 2% gain for SDS and a 3% gain for BGZ.

Example: leveraged (long) ETFs

On the flipside, the objective of the Ultra S&P ProShares (NYSEArca: SSO) is to deliver 2x the performance of the S&P 500 while the Direxion Large Cap Bull 3x Shares (NYSEArca: BGU) aim to deliver 3x the performance of large cap stocks as represented by the Russell 1000 Index (NYSEArca: IWB), there is no triple leveraged long ETF linked to the S&P 500.

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In a perfect world, SSO will gain 2% if large cap stocks are down by 1% while BGU would gain 3%.
Direxion, ProShares and Rydex are the only three companies to offer short and leveraged ETFs. PowerShares and Van Eck offer ETNs linked to various commodities and currencies.

Pitfall #1: Tracking error

The objective of leveraged ETFs is to deliver a multiple of the underlying index’s DAILY performance. Notwithstanding smaller margin of errors, most ETFs are able to live up to their objective.

There is the misconception however that the magnified DAILY performance multiplied by a longer period of time will also result in accurate long term performance mirroring. This is not so.

Due to the compounding effect of leveraged performance, the long-term performance of leveraged ETFs can deviate substantially from the underlying index. According to an in-depth study by ETFguide.com, the performance tracking error becomes particularly pronounced during periods of volatility.

The fourth quarter of 2008 marked such a period of volatility. Even though the Dow Jones (NYSEArca: DIA) was essentially range bound, some leveraged short ETFs deviated from their perceived long-term objective by 20% and more.

From the November 21st, 2008 lows to February 27th, the Russell 2000 (NYSEArca: IWM) gained a mere 2.38% while the UltraShort Russell 2000 ProShares (NYSEArca: TWM) lost 25.41%. From 11-21-2008 to 3-3-2009, the Russell MidCap (NYSEArca: IWR) recorded a gain of only 2.77% while the UltraShort Russell MidCap ProShares (NYSEArca: SDK) tumbled 28.35%. The UltraShort Financial ProShares (NYSEArca: SKF) even lost 45.53% during a timeframe where the iShares DJ US Financial Sector (NYSEArca: IYF) broke even.

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As much as volatility, especially in combination with a non-directional market, hurts the performance of leveraged ETFs, a directional market actually helps the performance of leveraged ETFs. This, once again, is due to the effect leverage has on compounding interest.

Pitfall #2: Taxes 

In order to manufacture magnified returns, leveraged ETFs have to resort to investment strategies that include swaps and futures. Swaps and futures are the most effective way for short ETFs to create the inverse performance. This however also disqualifies them from the traditional in-kind redemption process which has given ETFs a reputation of tax efficiency. Up to 85% of leveraged long ETF assets could be allocated to securities of the underlying index with the remaining portion invested in swaps and futures.

Tax distributions for many ETFs reached double digits in 2008. Shareholders of the Rydex Inverse S&P Energy ETF (NYSEArca: REC) got hit with distributions in excess of 80%. The UltraShort Industrial ProShares NYSEArca: SIJ) paid a taxable distribution of over 44%. This tax hit can be avoided by simply not owning susceptible ETFs on the ex-dividend date. The ETF Profit Strategy Newsletter has and will continue to let investors know in advance when the ex-dividend date is coming up.

Pitfall #3: Leverage

If you are looking for a way to make or lose 60% in a few days, double or triple leveraged ETFs are the solution. The Ultra Real Estate ProShares (NYSEArca: URE) and its leveraged short cousin the UltraShort Real Estate ProShares (NYSEArca: SRS) can fluctuate 25% and more on any given day.

Such leverage needs to be respected and used responsibly. Buying a leveraged (long or short) ETF at an inopportune time may set your portfolio back real quick.

Even though leveraged ETFs have their flaws, those flaws are far outweighed by their benefits. The key is knowing how and when to use them. Just like a power tool, leveraged ETFs can do a lot of good when applied correctly and cause a lot of damage if used haphazardly.

Timing is key

As with so many investments and strategies, timing is key. The leveraged nature of these ETFs compounds the need for timing even more. The ETF Profit Strategy Newsletter has proven a good source for finding the right entry and exit points.



The December 15th newsletter recommended to add  (leveraged) short ETFs above Dow 9,000. From January 2nd to January 6th, the Dow sat above 9,000. The subsequent 2,700 point loss in the Dow resulted in triple digit gains for a number of recommended short ETFs.

The January newsletter identified Dow 6,000 to Dow 6,700 as target range for a bottom. On March 2nd, just a few days before the Dow bottomed at 6,440, subscribers on record received a Trend Change Alert with the recommendation to buy leveraged long ETFs. Truly, leveraged ETFs are a wonderful tool if used correctly.