Inverse ETFs Gain Acceptance in Market Rout

The blood bath in the stock market has thrust inverse ETFs into the spotlight.

Only 61 of the 839 exchange-traded funds tracked by Morningstar have produced gains this year. The top 25 ETFs are all inverse funds, which move in the opposite direction of their underlying indices.

The growing popularity of these instruments was underscored when Direxion Shares launched a class of inverse ETFs that seek to achieve 300% of the daily performance of the four Russell indices they use as benchmarks. They are the Large-Cap Bear 3x Shares ( BGZ), Small-Cap Bear 3x Shares ( TZA), Energy Bear 3x Shares ( ERY) and Financial Bear 3x Shares ( FAZ). Direxion Shares also started four "bull" ETFs, which aim to return investors 300% of their underlying indices.

"The volume on the funds has ramped up very quickly, particularly in the large-cap and small-cap funds," said Andy O'Rourke, vice president and marketing director at Direxion Shares.

O'Rourke credits the leverage feature as being instrumental in the initial success of the ETFs. "In our current market environment, it is becoming more difficult to obtain leverage," he said. "Our funds offer a simplified way to obtain leverage."

These ETFs are not for the faint of heart, given their immense leverage. To give a sense of how volatile they can be, one only needs to look at FAZ. It opened at $103.49 on Nov. 19 and nearly doubled as it reached a high of $201.86 on Nov. 21. By Nov. 26, the shares had plummeted to $61.39.

Although inverse ETFs have only been trading for a little over two years now, they have gained wide acceptance. "They are wonderful things to have. You can profit as the market goes in either direction," said Jim Porter, portfolio manager of the Aston/New Century Absolute Return ETF Fund ( ANENX).

The use of inverse ETFs and a healthy cash position has enabled Porter to significantly outperform the market. Over the past six months, his fund is down 24.8% vs. minus 35.8% for the S&P 500. There have been periods during 2008 when his fund has had about 10% of its assets invested in inverse ETFs.

Porter cautions investors who opt to use inverse ETFs, especially leveraged inverse ETFs, that they must remain particularly attentive. "They go up very quickly, but go down very quickly as well," he said. "You can end up giving back profits from them in an emotional market. You almost have to be glued to your desk to use them effectively."

Given the tendency for some leveraged inverse ETFs to have large gaps between their opening price and the previous day's close, Porter notes that it is often smarter to walk away from the table after quick hits rather than waiting for a correction. "You have to treat them like a parabolic move up," he said. "You almost have to sell them while they are on their way up."

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