Looking Deeper Into the Pitfalls of Short Sector ETFs

Please note that this article was revised on Friday, Dec. 26.

Eric Oberg's two-part article on short sector ETFs attracted a tremendous response from RealMoney readers. Oberg worked in fixed income, currencies and commodities for Goldman Sachs for 17 years before retiring as a managing director. His skeptical view of short sector ETFs proved to be an eye-opener for many readers.

In Part 1 of the article, Mr. Oberg demonstrated how, even if you are spot-on in your bearish call on the market, a short sector ETF can work against you and actually give you worse returns than a long position. The fatal flaw of short-side ETFs, he said, is that "the daily rebalancing of the portfolios in combination with the market volatility and the leverage ... has eaten into the returns of what appeared to be a savvy bet."

In Part 2, he explained how short sector ETFs add volatility and sabotage their own performance. As Oberg said, "you begin to see significant underperformance in these levered short-sector ETFs, likely because these funds are having an inordinate effect on their sectors -- and the volatility they help create leads to their own demise." Moreover, he said that these instruments are not suitable for professional traders.

Many of you have had positive comments and further questions about this analysis of short-side ETFs. As always, we welcome your feedback. And if you'd like to join the lively discussion on this subject, you can do so on our Stockpickr site.

Here are some of your comments and questions, and Oberg's responses:

Couldn't I short the short index and short the long index and capture the inefficiency of the short volatility position?

Oberg: I am not advocating any trading strategy here -- just pointing out the myriad issues of a bifurcated marketplace and a flawed structure for long-term efficacy, and apparently blatant abuse of the margin rules. These things are extraordinarily complicated, and as we have seen, they may not work in the manner you think they will. I believe that if the market would have just gone down in a straight line, with no volatile retracements, you could have been killed employing such a strategy. As I mentioned, it looks as though there is an element of path dependency to these returns, and I have not studied enough to figure if such is a valid or foolhardy strategy.

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At the time of publication, Oberg had no positions in the stocks mentioned.

Eric Oberg worked in fixed income, currencies and commodities for Goldman Sachs for 17 years before retiring as a managing director.