Published: August 19, 2009

The S&P 500 Index is down -31.9% from where it was two years ago. I bet you wish you had been shorting the market since then. If you were short -- holding an investment designed to return the inverse, or opposite, of the market -- you could have made +31.9%. Or better yet, there are funds that double-short the S&P 500 Index. These "ultra" short funds are designed to double the inverse of the S&P's performance. Theoretically you could have made +63.8% on an ultra short S&P 500 fund.

But sometimes you have to be careful what you wish for...

Brilliant investors that saw the downturn coming and invested in short or ultra short S&P funds didn't make +63.8%. They didn't even make +31.9%. They LOST money!

This wasn't just a fluke or an S&P 500 Index anomaly. In fact the problem is so pervasive, the Securities and Exchange Commission and the Financial Industry Regulatory Authority just issued a joint press release warning investors about it. They warned that the performance of inverse (short) and leveraged (ultra) exchange-traded funds (ETFs) can substantially deviate from their designed benchmarks. More to the point, they said these funds "can turn into a minefield for buy-and-hold investors."

To state it more clearly: Leveraged and inverse ETFs can lose money, even when they shouldn't.

The premise of these funds is simple -- to short, double, or triple an underlying benchmark or index. ETFs are easy to trade and inexpensive to own. Investors were comforted to know there were funds designed to help them hedge against portfolio losses in a down market. They also became popular with speculative investors looking to double or triple their bets on market, commodity and currency indices.

But as simple as the premise is behind leveraged and inverse funds, the execution is far more complicated. These specially-designed funds use highly complex financial instruments that don't always yield the intended result. While they can be fairly accurate on a day-to-day basis, their accuracy degrades over time or during periods of increased volatility.

To see how this happens, let's look at the performance of the S&P 500 along with three leveraged and/or inverse S&P ETFs.

In the short-term, the funds look like they work well enough. In the chart below you can see how the S&P 500 short and ultra funds roughly track what they are supposed to. Although even after only six months, the inverse and leveraged funds are a little off their mark.

The accuracy problem becomes even more pronounced, however, over the long term.

After two years, each of these inverse and leveraged funds lost more than they were designed to. And in fact, not one of them was profitable.

The double S&P fund was designed to deliver twice the S&P 500's performance and should have lost -63.8%. Instead it lost more: -65.3%. The short S&P fund should have gained +31.9%: it lost -2.7%. And the double-short S&P fund, should have gained +63.8% -- instead, it lost -17.3%. That's a big loss for an investor who had it right all along.
 

Inverse and leveraged funds are still very valuable tools for investors. They can protect them against market corrections and even produce above-average returns for short-term index plays. But their uses may be far more limited than what investors believed or were led to believe.

A number of brokerages have already issued warnings to their clients about the problems associated with leveraged and inverse funds. Charles Schwab has put up an educational article about them on their website. UBS Wealth Management has suspended buying leveraged ETFs entirely. I suspect we'll see fund prospectuses changing throughout the industry.

While it's good to know the shortcomings of these funds are getting more attention, I can't help but think about the poor investors who had to learn the hard way. The market is tricky enough. Smart investors who make the right call deserve to gain from getting it right.

Always Searching for the Next Great Idea...

-- Amy Calistri
Editor
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