An Easier Way to Short Emerging Markets

Stock market bears are getting some new tools.

ProShares, the only provider of exchange-traded funds that short the U.S. stock market, is rolling out a family of products that bet on declines in international equities.

The first two debuted on the American Stock Exchange last week: The Short MSCI EAFE ( EFZ) is designed to produce the inverse of the daily return of the Morgan Stanley Capital Investment Europe Australasia Far East index, the most widely followed U.S. benchmark for tracking international equities, while the UltraShort MSCI EAFE ( EFU) returns two times the inverse of the index.

The Short MSCI EAFE began trading at $70.20, and the UltraShort MSCI EAFE started at $70.32 on Wednesday.

Next month, the Bethesda, Md., company expects to launch four more products that make more specialized bets: the Short MSCI Emerging Markets (EUM), Ultrashort MSCI Emerging Markets (EEV), UltraShort MSCI Japan (EWV) and the Ultrashort FTSE/Xinhua China 25 (FXP), which tracks the 25 largest companies by market-cap that operate in mainland China.

The MSCI EAFE is considered the granddaddy of international indices, and the short ETFs provide an efficient way to bet against stocks around the world. But the ability to short emerging markets stocks should be particularly appealing to investors who fear these markets are becoming overvalued.

China stocks have been surging over the past year and many investors fear the market is entering bubble territory. So far this year, world stock funds have returned 16.5%, according to Morningstar. However, the big gains have been in diversified emerging markets funds, up 43.5% year to date, and Pacific/Asia funds excluding Japan, the category China falls in. These have surged 64.6% this year.

"It's very difficult to put in short positions in emerging markets, so these ETFs will make it much easier to hedge," says Peter Schiff, president of Euro Pacific Capital, a Darien, Conn., brokerage, and author of Crash Proof: How to Profit in the Coming Economic Collapse.

He adds that making hedging easier is actually a bullish move for the emerging markets. That's because it lowers the investment's risk, making it more attractive. The ETFs offer insurance on the market going lower. Once there is a way to protect against declines, people should be more willing to take the risk of going long, which will push the market higher.

"I'm more interested in buying the pullbacks in emerging markets than going short," Schiff says.

Investors short stocks and futures when they think the market will go lower. Typically, when an investor shorts an individual stock he needs to set up a margin account, then borrow the shares in order to sell them. The short seller profits if the market falls so he can buy the shares to repay the loan at a lower price.

ProShares describes its products as ETFs that go up when the market goes down. Out of its family of 54 ETFs, 29 short the U.S. market. And of the 29 U.S. shorts, 22 are double shorts, giving twice the inverse move of the market.

While inverse funds can play a role in hedging the portfolios of ordinary investors, "the double inverse ETFs are strictly for traders," says David Fry, founder and publisher of ETF Digest.com, an online investment newsletter. "But I'm glad they are coming out, because when you need them, and who knows when that will be, it's good to know they will be there."

The expense ratio for all the ProShares funds is 0.95%, one of the highest expense ratios charged by any ETF company. That's partly a function of their design. The funds don't short individual stocks. Instead they short index futures contracts and buy swap agreements, which are contracts between two parties to exchange a revenue stream.

It's important to understand that the short ETFs are designed to produce the inverse performance of a given index on a daily basis. That means their performance can move out of line with their benchmarks over longer periods of time.

"On a market price basis, both sets of ETFs usually delivered 70% to 130% of their daily expected return. Over longer time periods, ProShares ETFs are unlikely to precisely double benchmark returns," Paul Mazzilli, the director of ETF research at Morgan Stanley, said in a report earlier this month. The interest income of inverse ETFs and fund expenses contribute to this discrepancy, he wrote.

To hear ProShares Chief Executive Officer Michael Sapir discuss the new ETFs, click here.

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