This article is by Eric Oberg, who worked in fixed income, currencies and commodities for Goldman Sachs for 17 years before retiring as a managing director. To join a discussion about short ETFs, please visit our special forum on

What would you say if you bought an index fund, only to find out that it lagged the benchmark by 30%? 80%? Over 100%? I am sure you'd be dismayed, disappointed and disgruntled.

What if you had perfect foresight and decided at the beginning of this year to go short U.S. real estate and short financials? What if I told you about an easy way to implement these trades, and to implement them with two or three times leverage? You'd expect to clean up, right?

What if I told you that if you were spot-on with your market call, positioned half of your portfolio in each short, you would still be down 23.4% year to date?

That's better than the overall market, sure, but still a little perplexing, I mean, how could you be down for the year with one of the most prescient market calls of all time?

Yet this is exactly what would have happened if you were long the double-levered short-biased ETFs on the U.S. real estate and financial sectors year to date. In fact, one would have been better off being short the double levered long funds vs. long the double levered short funds to implement this strategy.

Given that the double-levered long-side ProShares Ultra Real Estate ETF ( URE) was down nearly 80%, one would expect its complement (the ProShares UltraShort Real Estate ETF ( SRS)) to be up 80% instead of losing nearly half of its value, given they are based on the exact same index, right?

The same goes with the financial sector ETFs. Given that the double-levered, long-sided ProShares Ultra Financial ETF ( UYG) was down nearly 85%, you'd expect its complement (the ProShares UltraShort Financial ( SKF)) to be up 85% rather than flat. As the car rental commercial says, "Not exactly..."

How Short ETFs Can Work Against You
Jan 2, 2008 close
Dec 17, 2008 close
YTD Return
URE (2x long RE)
SRS (2x short RE)
DJ US RE index
UYG (2x long Fin)
SKF (2x short Fin)
DJ US Fin index
ETF Data Source: Yahoo! Finance
Index Data Source:& Barclays

What makes this even more bewildering is that ETFs, with their create/redeem process, should eliminate or curtail arbitrage, so there should not be any significant net asset value distortions, and that indeed does not appear to be the case.

To be fair, these funds do exactly what they set out to do -- track the daily changes in these indices. But that is also their fatal flaw as any sort of long-term investment or portfolio hedge. It is the daily rebalancing of the portfolios in combination with the market volatility and the leverage that has eaten into the returns of what appeared to be a savvy bet. And the irony of it all is that these funds, due to their structure, actually contribute to the volatility, thus directly contribute to their own failure as instruments for anything other than a day trade.

The following is a little bit of an over-simplification, because there are elements of path dependency, the element of compounding slight NAV deviations that affect returns and a few other technicalities, but let me try to explain how on earth it is possible to be double short an index that is down 40%, yet still be worse off than if you were long that index.

I am sure most people are familiar with the concept that if you go down 20% one day, then up 20% the next, you are still worse off than when you started (100 times 0.80 equals 80, and 80 times 1.20 equals 96). This is similar to what happens with these double-levered short side ETFs (the two-times long-side ETFs look like they do what they should), you get shorter on the way down, making bounces hurt more, because you lose more of your capital account.

So when you're frequently rebalancing, volatility nibbles away at your returns. When volatility goes to extreme levels, it eats away at your returns ... and with leverage, it devours your returns. This is essentially a short volatility position, and the short volatility position can outweigh the short index position, as evidenced by the returns in the chart. So these ETFs are not quite as effective as one would think as a mainstay in the portfolio, as a hedge or otherwise; in fact, they may be completely ineffective, or even counterproductive, at achieving objectives.

What's worse, though, is that by their very construct, these ETFs exacerbate the volatility. By bifurcating an index into long side and short side ETFs, they eliminate an "out" for the market maker, causing the market maker to actively hedge in the underliers. With a normal security, all buyers and all sellers come to a central meeting place, and buyers can be matched easily with sellers, and we reach price discovery. But when you set up a specifically one-sided instrument, rather than one common product that people can be either long or short, you contribute to dislocations.

Very few people would decide to go long an index by shorting the short-sided index ETF -- they'd just go buy the long-sided ETF. These products purposefully segment the longs and the shorts, and that, by definition, creates illiquidity. (Although I have to admit, this is an ingenious idea for the fund manager -- if they just had one product where longs and shorts could meet, some of those would cancel each other out, and they'd have less assets under management than they get by herding the bulls and bears into different products.)

So if someone buys that short-sided ETF from a market maker, the market maker does not really have "the other side" to mitigate his risk, thus he either waits for someone to unwind a pre-existing position or he goes out and shorts the underlier. This puts pressure on the underlier, which creates more interest in being short. This, magnified by the leverage, magnifies the volatility, which magnifies the negative convexity, which eats into returns. Thus the "savvy trader" who thinks he or she is doing a "smart trade" is contributing to his or her own underperformance while still having the right idea -- the wrong execution of the right concept.

Now here is a key point: This short-volatility position is kind of a compounding issue. If you compound at low yields, it is only slightly noticeable. If you compound at high yields, it becomes meaningful. Only in this case, instead of yield, think volatility. The more volatility, the more these levered short ETFs get clipped.

So if I look at a broad index, such as the S&P 500, and then look at the returns of the two-times levered long and two-times levered short ETFs, the returns are more or less mirror images, with the two-times short fund only slightly underperforming. This is because the volatility of the S&P 500 on a daily basis is not extreme.

Another way of saying it is that these two-times long and short funds are small fish in a much bigger pond -- the water is so deep, these barely cause a ripple in the much larger market (not to mention that the intraday hedging can be done in a liquid futures market). The activity in these funds does not influence the broader market; the tail does not wag the dog.

But these smaller sub-index funds are much bigger fish in a much smaller pond. The tail does wag the dog, and there is not a deep futures market with which to hedge. And here is where you begin to see significant underperformance in these levered short-sector ETFs, likely because these funds are having an inordinate effect on their sectors -- and the volatility they help create leads to their own demise.

I took two recent trading days looking at the SKF (the ProShares Ultrashort Financial, SKF, the two-times levered short financial sector ETF), and just at a high level looked at the dollar volume in the ETF traded that day, and compared it with the dollar volumes traded in some of the underliers. Note, that isn't to say that every dollar traded in the ETF translated directly into dollars traded in the underliers, but the results were pretty staggering.

The SKF closed Wednesday, Nov 19, at $222 and change. Daily volume has averaged 31.5 million shares (volume was actually slightly lower than that on the 19th). Now, this is not scientific (or indeed even accurate), but it just gives you a sense. At $222 and average volume of 31.5 million, that means (if every share sold at the close, which it didn't, but again this is just to illustrate a point) that the day's dollar volume in this short ETF was close to $7 billion. Since this is double levered, that is really close to $14 billion in volume in the sector. I understand that each trade represents a buyer and a seller of the risk, but bear with me here.

The same day, Goldman Sachs ( GS) closed at $55, with roughly 30 million shares changing hands, representing 1.65 billion of dollar volume. Citigroup ( C) closed at $6.40 with a (then) whopping 340 million shares changing hands, representing 2.2 billion in dollar volume traded. JPMorgan Chase ( JPM) traded 90 million shares and closed at $28 and change, so roughly $2.5 billion to $2.6 billion in dollar volume. Merrill Lynch ( MER) had about $1 billion in dollar volume. The volume created by the SKF swamps all of these.

On Dec 4, assuming average price of $135, the SKF traded 29,248,827 shares, representing just shy of $3.95 billion in dollar volume traded. Since this is a double-levered product, that represents just under $7.9 billion of volume in the underliers. Goldman Sachs traded 23,838,644 shares at an average price of around $68, giving us roughly $1.6 billion in volume. Goldman accounts for 2.59% of the index associated with SKF. That means that basically, $204,610,000 of the $7.9 billion in SKF was associated with Goldman Sachs, or roughly one-eighth of the day's volume in Goldman.

Again, these are rough calculations and just two random days, but I think you get a sense of the size of the fish relative to the size of the pond. There are by far more scientific ways to establish whether or not these influence the daily price discovery process -- but as a hint to those that may look into this, just start by looking at the sectors that do not have symmetric returns between the two-times long and two-times short ETFs, as those are the sectors where volatility has reigned. I must admit, there is a delicious irony in the fact that if indeed these ETFs have contributed to the extremes we have seen in these sectors, that those that caused the volatility have also paid their price.

So why do these products exist? Well, if you read the marketing literature, it says that these products "make it simple to execute sophisticated strategies, like shorting or magnifying your exposure to major indexes. No margin account. No margin calls. It's as simple as buying a stock." Basically, that is just another way of saying these ETFs are an easy way to get around the margin rules.

These products, contrary to popular belief, are not made for professionals; in fact if you talk to most institutional ETF desks on the Street, they will tell you they see very little activity from institutional investors in these products. That, in fact, makes sense, because an institution can find more efficient ways to be short or to be leveraged. Actually, anyone with a margin account can find more efficient ways to be short or leveraged (unless they are really ramping up their leverage by buying these on margin). The only reasons I could think of that someone would "invest" in these products would be because they a.) expressly lacked sophistication, b.) were trying to skirt the margin rules, or c.) were attempting to manipulate the markets.

To be sure, some institutional investors appear on the shareholder rolls of these products. (Would you be surprised if I told you Bernie Madoff shows up as a holder? He held 7,638 shares of SKF as of Sept. 30, 2008). But if I were an investor in a hedge fund that was short the market in such an inefficient manner, I'd either question their due diligence if they thought this was the best way to effect a trade, or I'd question their scruples if they were attempting to manipulate the market. Either way, I'd really question paying them "2 and 20" on top of the 95 basis points in fees that the ETF is taking out. If you have hedge fund investments that hold these securities, ask them for a return attribution.

According to a December 1995 piece in The Journal of Finance, an article by Mayhew, Sarin and Shastri, "Federal Regulation of Securities margins was mandated by Congress in October 1934 to promote market integrity and curb excessive volatility" emphasis added . So again, why do these products exist when they seemingly do neither?

If you wish to add leverage to your portfolio, you typically need to do so in a margin account, which means you need to meet suitability requirements and sign a hypothecation agreement. If you wishes to short a security, you need to establish a margin account, meet the suitability requirements, sign a hypothecation agreement, plus obtain a borrow. Yet these ETFs can be traded in a cash account, effectively sidestepping the margin requirements - remember, "It's as simple as buying a stock"!

Hmmm ... providing leverage and easy access to shorting the market ... that doesn't exactly sound like promoting market integrity and curbing excess volatility now, does it? The fact that so much expected return on these instruments gets eaten away by the volatility should tell you something about their efficacy.

The magnified volatility has also rendered moot many long standing market practices -- for instance, with these things it would be very difficult to reinstate the uptick rule, and they make it difficult to regulate naked short-selling, because "It's as simple as buying a stock." Furthermore, for those who follow technical analysis, cycles become much more compressed, and Fibonacci levels are no longer sacred because there is no speed governor when indiscriminate two-times and three-times levered index products are involved (and this counts in up markets just as much as in down markets) -- thus, "signals" really aren't signaling anything.

These levered and short sided ETFs are an endless series of paradoxes. They are set up to benefit from market moves, but the more volatility, the less accurate they are in achieving that objective. They market themselves as an easy way to provide sophisticated trading strategies, yet the true sophisticated investor can implement more effective trading strategies themselves. They do their job following daily moves, yet they make for a lousy long term hedge or trade. They offer the layman investor a chance to protect against volatility, yet they help contribute to and exacerbate that volatility because of their construct.

The double-levered short financials ETF is backed by -- you guessed it -- a swap with a financial. Despite having margin requirements to "promote market integrity and curb excessive volatility," these somehow have been allowed to proliferate in the market. And the biggest paradox of all is that you could have been spot-on accurate with your bearish call, yet still ended up in the red.

I realize some may say, "I hear you on that, but these just make it so easy for me to implement my strategy." OK, maybe so. But if you would have just been short the two-times long Ultra Real Estate instead of long the two-times-short UltraShort Real Estate since the beginning of the year, you'd have three times as much capital in your account right now. That's some price to pay for ease of use! At least the offering documentss state, "There is no guarantee these products will achieve their investment objective." You can say that again.

Editor's note: This article originally appeared on RealMoney, a premium subscription site from RealMoney provides investment ideas, trades, analysis and commentary from more than 60 contributors. Please click the following link to learn about how you can get a subscription to RealMoney.
At the time of publication, Oberg had no positions in the stocks mentioned.

Eric Oberg worked in fixed income, currencies and commodities for Goldman Sachs for 17 years before retiring as a managing director.

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