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How Short ETFs Make Money
01/11/08 - 01:52 PM EST
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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.
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