Everyone knows about short and leveraged exchange traded funds (ETFs), but some might be wondering "How do they do that?"

Michael Sapir, CEO of ProFunds, gave us a call and explained it. "The best way to understand how a [short or leveraged]fund works is to compare how an S&P fund works."

If, at the end of the day, there is $100 in this fund, the manager of that fund will want to take that $100 and get the equivalent exposure to the S&P. Exposure can be had in several ways:

  • By buying securities that make up the S&P, in the same proportion that they’re in the index
  • Buy futures contracts on the S&P
  • Swap agreements with counterparties

"What you want is an accumulation of stuff, baskets of securities that represent the S&P that relate to the amount of money you have in the fund," says Sapir.

Long and short ETFs work in a similar way.

A long fund, such as the Ultra S&P 500, seeks to double the returns of the S&P 500. That means when the index goes up, your returns will double that.

If a fund looking to double the S&P has $100, "We want to have stuff in our fund that gives it exposure of roughly $200 to the S&P."