Inverse ETFs on Market's Good Side

The market's drop has played into the hands of inverse ETF providers.
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The bear market of 2008 has provided a launching pad for inverse exchange-traded funds.

Inverse ETFs have been in existence for about two years, yet the timing of their origination couldn't have been any better. In summer 2006, the

ProFunds Group

launched the

Short QQQ ProShares Fund

(PSQ) - Get Report

the

Short S&P 500 ProShares Fund

(SH) - Get Report

, the

Short Dow 30 ProShares Fund

(DOG) - Get Report

and the

Short MidCap 400 ProShares Fund

(MYY) - Get Report

. These were the first ETFs that allowed investors the ability to gain short exposure to well-known market indices.

The idea for this family of ETFs dates to 1997, when ProFunds launched bear market index funds that were targeted towards investment professionals. "We knew early on that these funds had a real place in the world of investing for the registered investment adviser market," says Steve Cohen, managing director at ProShares. "The ETFs were launched to give other audiences access to this short exposure."

The ProShares family of ETFs, which also includes ETFs that are designed to provide magnified exposure to underlying indices, surpassed $1 billion in assets within three months of their launch. "It's been a phenomenal story," says Cohen. "It's been the most successful ETF product launch ever. At the end of 2007, we had about $10 billion in assets after just 18 months. This year we surpassed $21 billion in total ETF assets."

The market's volatile path this year has played right into the hands of inverse ETF providers. The deteriorating financial sector has been a popular play for investors who have utilized inverse ETFs. The

UltraShort Financials ProShares Fund

(SKF) - Get Report

, which aims to return twice the inverse of the performance of the Dow Jones U.S. Financials index, has a market cap of about $4.2 billion.

The financials index includes names --

Bank of America

(BAC) - Get Report

,

JPMorgan Chase

(JPM) - Get Report

,

Citigroup

(C) - Get Report

,

American International Group

(AIG) - Get Report

, and

Wachovia

(WB) - Get Report

-- that have been battered this year.

SKF is up about 25% year-to-date despite having pulled back substantially since it hit a 52-week high in mid-July. "This ETF is a great way to hedge out financial exposure in a broad portfolio," says Cohen. "And you don't have to have the unlimited exposure of taking a short position."

New Perspectives

Because inverse ETFs give investors easy access to short positions, they no longer need to remain on the sidelines when the market heads south as it's done recently. "Inverse ETFs give investors a two-dimensional view of the market," says Jim Porter, portfolio manager of the

Aston/New Century Absolute Return ETF Fund

(ANENX)

. "By using these ETFs, investors now have the ability to benefit from both rising and falling markets."

Another advantage of inverse ETFs that Porter emphasizes is the ability to hedge short-term risk. Porter offers this example: An investor has taken a bullish long-term position in oil by using the

Oil Service HOLDRs Trust

(OIH) - Get Report

. But the investor is concerned the price of oil might drop sharply in the near-term. Instead of trading in and out of the position and incurring additional trading costs, Porter says the investor could use the

UltraShort Oil & Gas Proshares Fund

(DUG) - Get Report

as a viable option to hedge this position.

"Inverse ETFs give you the ability to expand your holding period in a long position comfortably," he says. "They enable you to hold on to a long position for a longer time frame because you are able to use the inverse ETF to subtract out a short-term risk."Porter regularly uses these inverse ETFs in practice. As of June 30, his fund had positions in DUG as well as the

UltraShort Dow 30 ProShares Fund

(DXD) - Get Report

.

At the time of publication, Fisher was short Bank of America.