Why Short Sector ETFs Aren't So Smart

Again, these are rough calculations and just two random days, but I think you get a sense of the size of the fish relative to the size of the pond. There are by far more scientific ways to establish whether or not these influence the daily price discovery process -- but as a hint to those that may look into this, just start by looking at the sectors that do not have symmetric returns between the two-times long and two-times short ETFs, as those are the sectors where volatility has reigned. I must admit, there is a delicious irony in the fact that if indeed these ETFs have contributed to the extremes we have seen in these sectors, that those that caused the volatility have also paid their price.

So why do these products exist? Well, if you read the marketing literature, it says that these products "make it simple to execute sophisticated strategies, like shorting or magnifying your exposure to major indexes. No margin account. No margin calls. It's as simple as buying a stock." Basically, that is just another way of saying these ETFs are an easy way to get around the margin rules.

These products, contrary to popular belief, are not made for professionals; in fact if you talk to most institutional ETF desks on the Street, they will tell you they see very little activity from institutional investors in these products. That, in fact, makes sense, because an institution can find more efficient ways to be short or to be leveraged. Actually, anyone with a margin account can find more efficient ways to be short or leveraged (unless they are really ramping up their leverage by buying these on margin). The only reasons I could think of that someone would "invest" in these products would be because they a.) expressly lacked sophistication, b.) were trying to skirt the margin rules, or c.) were attempting to manipulate the markets.

To be sure, some institutional investors appear on the shareholder rolls of these products. (Would you be surprised if I told you Bernie Madoff shows up as a holder? He held 7,638 shares of SKF as of Sept. 30, 2008). But if I were an investor in a hedge fund that was short the market in such an inefficient manner, I'd either question their due diligence if they thought this was the best way to effect a trade, or I'd question their scruples if they were attempting to manipulate the market. Either way, I'd really question paying them "2 and 20" on top of the 95 basis points in fees that the ETF is taking out. If you have hedge fund investments that hold these securities, ask them for a return attribution.

According to a December 1995 piece in The Journal of Finance, an article by Mayhew, Sarin and Shastri, "Federal Regulation of Securities margins was mandated by Congress in October 1934 to promote market integrity and curb excessive volatility" [emphasis added]. So again, why do these products exist when they seemingly do neither?

If you wish to add leverage to your portfolio, you typically need to do so in a margin account, which means you need to meet suitability requirements and sign a hypothecation agreement. If you wishes to short a security, you need to establish a margin account, meet the suitability requirements, sign a hypothecation agreement, plus obtain a borrow. Yet these ETFs can be traded in a cash account, effectively sidestepping the margin requirements - remember, "It's as simple as buying a stock"!