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 Stockpickr.com.

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
ETF
Jan 2, 2008 close
Dec 17, 2008 close
YTD Return
URE (2x long RE)
33.15
6.70
-79.8%
SRS (2x short RE)
110.42
57.19
-48.2%
DJ US RE index
605.69
368
-39.2%
UYG (2x long Fin)
39.22
6.09
-84.5%
SKF (2x short Fin)
104.00
105.47
+1.4%
DJ US Fin index
683.8
346.9
-49.3%
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.

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