Taking the Measure of the Double-Short ETF

A few weeks ago, I wrote about the ProShares Ultra S&P 500 Fund ( SSO). It is an ETF meant to capture twice the daily performance of the S&P 500 index; that is, it's double-long the market.

The converse of double-long is double-short. ProShares has now listed the Ultra Short S&P 500 Fund ( SDS), which is meant to capture twice the daily inverse of the S&P 500, double-short.

Using the open-end equivalent, ( URPIX) ProFunds Ultra Bear Fund, as a litmus test, the double-short ETF is likely to have tracking errors due to things like cash building up and rolling of derivatives owned in the ETF. To be crystal clear, I expect there to be a noticeable tracking error that will vary in size over time.

As in my column on the double-long ETF, I would like to focus on potential strategy for the double-short ETF. The prospectus will spell out the potential flaws better than I will, and is essential reading for anyone considering the investment.

I expect that, in time, the double-short ProShares will draw people looking to make big bets on market direction for short periods of time. The fund will be a good resource for this, because trading ETFs is cheap, and despite the thin volume in the instrument so far, the market should be reasonably deep. But consider this fair warning to use limit orders on any thinly-traded vehicle.

Another use for the double-short fund is in a defensive context for investors who do not consider themselves to be active short-term traders but who want one more way to take defensive action or reduce net exposure to equities.

I do not believe there is a reliable way to predict movements in the tracking error, so for the sake of discussion, I will assume that SDS perfectly captures twice the inverse of the S&P 500.

The primary role that the double-short ETF can play in a defensive strategy is to reduce net long exposure without selling a lot of stock. By selling down only 10% of an all-equities portfolio and plowing that 10% into the double-short fund, net equity exposure goes from 100% down to 70% without a lot of turnover.

The big benefit of this approach is that if this type of defensive action is taken at exactly the wrong time, there is still plenty of stock exposure in the portfolio. As the market goes up, the value of the double-short position will get smaller, creating less of a drag and allowing more and more of the portfolio to participate in the rally you did not see coming. Really, here, I am talking about the consequences of being wrong. Compare being wrong with this strategy involving the double-short ETF to what happens when you think the market is going to go down, you raise too much cash, it doesn't and you wind up having no idea when to get back in.

I am a big believer in having some sort of strategy that triggers defensive action. Taking the view from 30,000 feet, the point of taking defensive action is to try to miss the full brunt of a large decline. A double-short ETF or an open-end fund makes it easy and cheap for do-it-yourself investors to have a chance of sidestepping a portion of something nasty -- not a guarantee, but a chance.

Generally, I much prefer the trading flexibility of an ETF over an open-end fund. It's easy to envision a scenario where having to wait until 4 p.m. EDT to exit a double-short fund could be a huge disadvantage. For anyone interested in any type of double-short product, the $10 or $20 commission for the ability to trade during the day is well worth it.

One last point: There are flaws and quirks to the double-short ETF. All investment products have plusses and minuses, and the ProShares Ultra Short S&P 500 Fund is no different. For more about the flaws and quirks, read Barry Ritholtz's thoughts on the topic. He sizes them up very well. But make a decision about whether this product is for you by weighing its pros and cons and deciding for yourself.


Please note that due to factors including low market capitalization and/or insufficient public float, we consider ProShares Ultra S&P 500 Fund and the ProShares Ultra Short S&P 500 Fund to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.

At the time of publication, Nusbaum was long ProFunds Ultra Bear Fund and Ultra Short S&P 500 Fund for client accounts, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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