YIKES...My UltraShort ETF Just Tanked...!!

A: Have a day off today before the holidays and just wanted to wish everyone out there a very safe, enjoyable, and Happy Holidays!! I'm a bit burned out over here from past few months, so taking a day to trade a bit on what is a very slow volume day. When I woke up today I noticed something strange, something that those trading this market via ETF's may have noticed too. Although the market was set to open flat, one of my UltraShort positions was set to open down $25! WTF??? Well, for those that got scared too, there is a reasonable explanation why and the money will be credited back to you on Dec 30th!

Sorry for the off-topic piece here, but I need a break from discussing Manhattan real estate anyway. Here is the deal if you noticed a big haircut today due to some ETF holdings you may have:

ProShares recently declared distributions for 4th Quarter 2008 and are now trading ex-dividend, meaning the shares are trading without the distribution amount. This impacted the trading price and Net Asset Value (NAV) for these funds. The chart below details important dates related to ProShares distributions. Please visit www.proshares.com and click on the “View 2008 Distributions” button to view fund specific details.

Here are the details of the first 15 ETFs affected, a total of 52 out of the 76 ETFS were affected by this distribution (click on the image for all):



So, for example, I own some MZZ, which is the UltraShort MidCap 400 Index that tries to replicate the performance of 2X the inverse of the S&P MidCap 400 Index. It closed at $88, yesterday, and opened this morning at $63, a $25 difference.

If you notice the outlined row above, there was a dividend of $0.007783 and a short-term capital gain of $23.84952, distributed out of the index. So, what do you get back on the 30th? Here is the direct response from ProShares:

A payment will be made to your brokerage firm on December 30, 2008. Your brokerage firm will, in turn, place the payment into your brokerage account.

I've been trading these ETF's for over 18 months or so now, but this is the first time I held a position in one that was affected by this distribution, so it did catch me a bit off guard. A few other traders I know called me too about this, so I figured to at least pass on what I know from ProShares in case anyone out there was affected but didn't understand why. Just check your statement in a few days and you should see the credit there. If not, contact your financial adviser or your representative at your brokerage firm.

These ETFs are certainly fun to trade, and this is a great traders market, but recently there has been much disappointment about these vehicles that seek to duplicate 1x, 2x, and now up to 3x the performance of any one index or other ETF. One recent article came from Eric Oberg, over at TheStreet.com:

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?

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.

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.

Here's a visual example, that is interesting to say the least. It seems that these products are engineered to go down over time and with lower volatility. I can see some class action lawsuits forming already; however, I'm sure ProShares is protected via the product disclosure statements but that won't stop investors from trying.