Looking Deeper Into the Pitfalls of Short Sector ETFs

Furthermore, being short the long index exposes you to infinite pain should the market rise, whereas the short index gets stopped out at zero. So such a strategy in a sharp rally could crush you, and the leverage in these compounds the speed at which that could happen. There has been a lot of talk lately about the resurgence of Keynesian thought regarding the government's role in the economy; regardless of one's stance on the issue, I believe there is one thing Keynes said that we can all agree on and any investor should take to heart: "The market can stay irrational longer than you can stay solvent."

Why are you picking on ETFs?

I am not picking on ETFs. I own some ETFs, and have traded many in the past. In fact, while at Goldman, my team helped launch the iShares iBoxx Investment-Grade Corporate Bond ETF (LQD - commentary - Cramer's Take), the LQD, the first investment-grade corporate bond ETF, which I believe is a great product for people who want to take (or shed) indexed corporate bond exposure. (I love corporate spreads but am not wild about interest rate levels over intermediate to long term.) ETFs are a great way to take specific, passive exposures to various market segments.

What I am against is a specific sub-sector of the ETF universe, and that is the turbo group of ETFs that bifurcate and fragment liquidity in the marketplace, leading to the potential for market manipulation and representing a patent violation of the intent of the margin rules. These are asset-gathering ploys that make you either a willing participant in "the dark side" or the mug in the game. If someone wants to short me the ETF that I want to buy, then great -- that's what makes a market. But there is a tremendous difference between a market and a marketing gimmick.

But aren't these a chance for the "little guy" to get in on the action?

I have to say, watching individual investors play in these things is eerily like watching a moth circle a candle flame ... eventually you just know they are going to get singed. I mentioned in the article that there are only three reasons someone would play in these: 1.) They are uninformed, 2.) They were trying to sidestep the margin rules, or 3.) They were trying to manipulate the markets. The purpose of RealMoney is to help educate investors, so hopefully we can take care of the first reason by informing you fully of these products. It is the other two that are a problem. And if you still wish to trade in these things after becoming informed, then you are enabling the latter two reasons.

As mentioned in the Journal of Finance article I quoted, the margin rules are in place to "promote market integrity and curb excessive volatility." No one should be above these rules -- we shouldn't have naked short-selling, and we shouldn't have excessive leverage. If you want leverage or if you want to short, follow the time-tested market practices in place. To be clear, these are (currently) SEC-approved products. But you hopefully agree with me that there is a difference between following the letter of the law and following the intent of the law. If you care about market integrity, do not enable people to violate the intent.

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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.