Making an Inverse Move

ProShares funds have taken in $1 billion in the leveraged and inverse fund market.
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After being on the market for just 11 weeks, a line of leveraged and inverse exchange-traded funds have accumulated more than $1 billion in assets.

In June, ProShares, a division of ProFunds, unveiled the ETFs, which essentially perform the same function as their mutual fund cousins.

Investors have historically turned to leveraged mutual funds to get returns that amplify the performance of an index, inverse mutual funds to seek returns that are the opposite of a specific index and leveraged inverse funds to generate returns that are the opposite of an index and then magnified.

For example, say a fund is using leverage to double returns. If the index being tracked returned 1%, the leveraged fund would seek to return 2%. With inverse funds, if the index fell 2%, the fund would aim to return 2%. Leveraged inverse funds would take the opposite of the index and magnify it, so if the index fell 2%, the fund would return 4%.

Some even speculate that the ETFs may be siphoning assets away from the mutual funds, though there's no real evidence of that yet.

But their success doesn't mean, of course, that the ETF version of these vehicles is superior, or that it's for everyone. In many ways, weighing the advantages of the ETFs vs. mutual funds of the same breed is sort of like watching a dog chase its own tail.

"Certainly ETFs offer a number of tremendous benefits for investors, but it's not a replacement for everything that has been working for so many years," says Kevin McGovern, vice president of business development at Rydex Investments.

Rydex is a big player in the inverse and leveraged mutual-fund space and also runs several ETFs, though none of the inverse or leveraged variety.

Some observers say the decision about whether to use leveraged and inverse ETFs or mutual funds comes down to comparing some fundamental differences between the two products, such as trading and costs.

To some extent, that's true.

But because the ProShares products are unlike other ETFs on the market, and because leveraged and inverse mutual funds behave a little differently than traditional mutual funds, some distinctions should be made.

Active Trading

For instance, one oft-touted advantage of ETFs is that they allow for intraday trading.

While this is beneficial for anyone looking to actively trade ETFs, this particularly applies to inverse and leveraged ETFs, as they seem to target more frequent traders.

Michael Iachini, director at the Schwab Center for Investor Research, says people who want to use these strategies "tend to be more active traders who speculate or hedge."

"That type of investor may have more need for the flexible trading of ETFs," he says, adding that if investors want to speculate, they may prefer using an ETF, where they can get in and out at any time.

Michael Sapir, chief executive of ProShares Advisors, agrees that the ETF version could be attractive to active traders.

"You can essentially go in and buy an ETF or liquidate your investment any time during the day," he explains. (ProFunds also has a variety of leveraged and inverse mutual funds.)

More Diversification, Less Risk

But active traders aren't the only ones who might have use for these inverse and leveraged products.

McGovern explains, "An investor should expect that the use of leverage and inverse strategies, on their own, would lead to increased volatility; however, if applied appropriately as a part of an investor's portfolio, these strategies can help achieve more diversification and ultimately less risk. This is something institutional investors have been doing for years."

Then there's the cost component to think about.

Basically, it goes like this: ETFs generally have cheaper expense ratios than corresponding mutual funds.

That's true in this case, too -- the ProShares are capped at 0.95%, while most leveraged and inverse mutual funds charge at least 1.6%.

But because ETFs trade like stocks, there is a bid-ask spread, and you must pay a commission each time you trade them.

But there is something else to consider: Most mutual funds frown upon frequent trading and often charge investors transaction fees when they sell a fund before meeting a certain holding period.

That's not necessarily an issue, however, with leveraged and inverse mutual funds -- neither Rydex nor ProFunds charge investors transaction fees for buying or selling their inverse or leveraged mutuals.

Many Variables

Ultimately, deciding between leveraged and inverse ETFs or mutual funds is a complicated process, Iachini says.

Before making a decision, investors need to take into account how much they're going to invest, the costs involved (including expense ratios, commissions, spreads and other fees), how long they plan on holding the investment and how often they expect to trade.

Some Web sites provide tools to help compare the costs of ETFs and mutual funds.

Rydex has an

online service

for financial professionals that calculates the number of trades, holding-period requirements, transaction/commission costs, annual expense ratio, share price and bid and ask spreads to determine whether an ETF or a mutual fund is more suitable in specific situations.

At this point, it's hard to say exactly who is using the ETFs and how they will co-exist alongside the mutual funds. Sapir says the products are being marketed to institutional investors, such as hedge and pension funds, financial professionals and sophisticated investors.

Going forward, Dave Fry, founder and publisher of investment

newsletter

ETF Digest, believes the leveraged and inverse ETFs will be used more by institutions and individuals, while the mutual funds will continue to get play from financial advisers.

The mutual funds have higher fees, and advisers can make money that way. With the ETFs charging roughly half of what the mutual funds charge, more do-it-yourself investors will use them, he says.

In addition, Fry says, there will be a big market for the ETFs in retirement accounts, such as IRAs and 401(k)s, which restrict shorting, or borrowing a security and selling it on the bet that it will fall and you can buy it back at a lower price.

With an inverse ETF, he says, "to go short you can go long. That is a huge market that is now going to open."

Russell Bailyn, a wealth manager with N.Y.-based financial planning and investment advisory firm Premier Financial Advisors, is not a fan of using ProShares ETFs as core portfolio holdings, but he agrees they could be good in an IRA.

The ProShares, he says, would be "a fairly low-cost way of shorting the market and having access to leverage."