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."
That exposure is gotten in much the same way: buying baskets of stocks that might give dollar-for-dollar exposure, along with futures contracts and swaps, which are inherently leveraged, Sapir says. "You don’t have to put down $1 to get $1 worth of exposure."
A short fund, such as the Shorts or UltraShorts, seek to provide either the opposite of the index, or twice the opposite. They can be a way to capitalize when the markets are heading south.
Shorts work in a similar way, with one key difference: "We don’t buy long positions because it’s a short fund." Short funds also don’t short stocks – Sapir says it’s not very efficient or effective. Instead, they primarily short futures contracts and swap agreements.
As it’s been said before, just be sure to use these products with caution – as much as they have potential to generate super-sized returns, they can leave a super-sized ding in your portfolio, too.
The access to profit from a declining market is both easy and profitable with the low expenses of these ETFs, and Don Dion for Seeking Alpha points out that the maximum the investor can lose with these types of funds is the initial purchase price. While leverage gives more exposure to an index with the same amount of money, market volatility can literally rip up a portfolio with one of these funds.
Some of the various long/short ETFs available these days are: