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How Short ETFs Make Money

Lawrence Carrel

I am now looking at some of the short and ultra-short ETFs as protection against a bear market. But I cannot get a handle on how these make money. Do they short the individual stocks in the index they track? And exactly how do the ultra-short ETFs try to double the return? -- E.W.

The short and "ultra" (or "double") short ETFs (exchange-traded funds ) offer a new way for investors to short the market while taking on less risk than shorting stocks outright.

About Shorting Stocks

Investors sell stocks short when they believe the market will go lower. Instead of buying low and selling high, the short-seller does the reverse: He sells high, and then, after the market has fallen, buys low.

Typically, when an investor shorts an individual stock, he or she needs to set up a margin account . Then, because the investor doesn't own the shares , he or she needs to borrow them from a broker in order to sell them. For this loan, he pays the broker interest. The short-seller sells the shares on the open market. He profits if the market falls so he can buy back the shares at a lower price.

However, short-sellers take on a lot of risk to hold a short position . If the market rises, the short-seller takes a loss by buying back the shares at a higher price. When you buy stocks, your maximum loss is the amount of your investment. But when you short stocks, your potential loss is endless.

Short ETFs

ProShares Advisors and Rydex Securities are currently the only companies issuing exchange-traded funds that short the U.S. and foreign stock markets. These ETFs go up in price when the market goes down.

Short ETFs, such as the ProShares Short S&P500 (SH), return the inverse, or opposite return of the index they are trading, which in this case is the S&P 500 Index (SPX). The ultra-short ETFs, such as the ProShares UltraShort S&P500 (SDS), return 200%, or double the negative return of the stock index, before fees and expenses. So if the S&P 500 falls 1%, the UltraShort S&P500 earns 2%.

"This is shorting made easy," says Michael Sapir, CEO of ProShares.

Among the many benefits to buying short ETFs is they're easier to trade. The investor doesn't need to set up a margin account or borrow shares or pay interest. In addition, the ETFs eliminate a lot of the risk involved in shorting. Instead of selling first and opening himself up to unlimited losses, the investor buys shares of the short ETF. The short ETF will rise when the market falls. He only risks the purchase price of the investment.

So, how do the ETFs do it? Well, for one thing, they don't short the "basket" of all the component stocks in the index. Rather, they use derivatives that don't have the trading costs associated with shorting.

These derivatives include index futures contracts and swap agreements, which are contracts between two parties to exchange an income stream. The index futures are sold, or sold short. The ETF also buys swaps with a negative correlation to the index; this is essentially shorting the swaps.

The swaps exchange the money, depending on the direction of the index. One interesting aspect of this is that the short side of the swap always receives an interest payment for allowing the long side to get the fund's potential upside. However, if the fund falls in price, the short receives both the downside returns as well as the interest.

In addition, futures are margined instruments which give leverage . The investor only needs to put a little money down for the potential of greater returns. For an ETF returning 100% of the negative return of an index, the ETF needs to put only 10% of its cash into the futures. If the ETF wants to see a 200% negative return, it puts 20% of its money into the futures. The rest of the assets are invested in short-term notes , which pay interest.

Special Considerations

Because of their unusual structure, the short ETFs are not as tax-efficient as ETFs that hold equities . They have special considerations. Because the shorted futures need to be bought back or rolled over, they will incur capital gains within the ETF. As with futures, 60% of the capital gains in the funds are taxed like long-term gains, currently a 15% range. The other 40%? Well, those are considered short-term gains, and that means they are taxed as ordinary income. The interest from the short-term interest-bearing notes is also taxed as ordinary income.

It's important to remember that the ETF companies only promise a target return of 100% or 200% on a daily basis. Fees and rollover costs will eat into returns. So over time, say for example, three months, the return will not be exactly 100% or 200% of the three-month negative return on the fund but a little less.

To learn more about short ETFs, check out these stories on TheStreet.com:

• "New ETF Offers Leverage and Pitfalls." The ProShares Ultra S&P500 aims to capture twice the move of the benchmark index.
• "Taking the Measure of the Double-Short ETF." A noticeable tracking error won't diminish its popularity as a directional bet, but it has another use.
• "Hedge Your Portfolio With 'Ultra' Short ETFs." ETFs that move in the opposite direction of stocks can help smooth the market's bumps.
• "An Easier Way to Short Emerging Markets." ProShares' latest ETFs let you bet on declines in global stocks.

To learn more about ETF investing, visit TheStreet.com ETF Center.