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Recent market turmoil and volatility has popularized short ETFs to nearly epic proportions. This meteoric rise in visibility provides an occasion for closer examination of five of the earliest of these funds, designed by ProShares in early 2007 to give investors short strategies in single sectors. ProShares launched the 22 sector pairs simultaneously, and Ultra Short Financials (NYSEARCA:SKF), Ultra Short Real Estate (NYSEARCA:SRS), Ultra Short Basic Materials (NYSEARCA:SMN), and Ultra Short Oil & Gas (NYSEARCA:DUG) currently have the highest three-month average daily trading volume out of the batch, all averaging well over a million shares per day. The ProShares Ultra Short sector funds are unique strategies that require unique consideration before investment. While the recent attention paid to SKF, SRS, SMN, and DUG has increased the perception of their accessibility, investors should examine the funds in relation to their “big picture” strategies and weigh the unique risks and rewards involved, before diving into the short end of the ETF pool.

ProShares sector ETFs were designed as pairs of strategies to track underlying Dow Jones formulated sector indexes. The ultra long ETF of each index would provide investors with a 200% exposure to the index while the ultra short strategy would offer a negative 200% exposure. The most highly traded sector ETF from ProShares, SKF, is based off the Dow Jones U.S. Financials Index (NYSEARCA:IYF) and has a corresponding ultra long ETF, UYG. The popularity of the ProShares ultra short products can be traced to the inherent riskiness of selling short equities in an open market, thereby exposing oneself to unlimited potential downside if the equity price goes up.

The pricing of an ultra long and ultra short pair should theoretically be equidistant from the value of the underlying index. If the underlying index goes up 10%, the ultra short ETF should fall 20% while the ultra long ETF should rise 20%. This mathematical relationship does not always hold in the open marketplace, however, and factors like investor interest and news events can cause some investors to abandon valuations and rush from one end of the short spectrum to the other. On Monday, December 1, the Dow Jones U.S. Realty Index fell 20.61% in intraday trading. URE, the ultra long ProShares realty fund, fell 41.55% over the course of the day while the ultra short real estate fund, SRS, rose only 35.73%. The difference in these values likely corresponds to the broader market picture—the Dow fell nearly 700 points during the day and the ultra long strategy had few buyers amid the sell-off. This could indicate that investors were more desperate to get out of the ultra long strategy than they were eager to invest in the ultra short strategy.

The accessibility of ultra short strategies during sharp downturns and short-selling bans is not guaranteed, however. When the SEC issued a short-selling ban for financials on September 18, 2008, investors poured into SKF, thereby skyrocketing volume. In response to the ban, ProShares suspended the creation of new SKF shares but could do nothing to diminish the demand for the available shares in the market. Investors, willing to pay the vig to get ahold of SKF, drove premiums to unprecedented levels—on September 19, Morningstar reported that SKF had closed at a market price 16% above the value of its holdings.

Unlike with individual equities, there is no gray area when determining the value of these sector ETFs. SKF should theoretically trade at 200% the exposure of IYF, and a dislocation in this pricing mechanism reveals the emotion inherent in any turbulent marketplace as well as plentiful arbitrage opportunities for enterprising traders. Individual investors should examine trading volume as well as an ETF’s relationship to its net asset value (NAV) before purchasing shares. The current market value and net asset value can be determined intraday through such trading programs as Bloomberg and is published at the end of the day through the ProShares site.

By observing trends in premiums and discounts, investors can get their money’s worth. Such observations can prevent an investor from paying $6 for an ETF worth $5. Subsequently, these trends can also prevent the same investor from having to sell that $5 ETF for $4 in the open marketplace. The ProShares ultra short ETFs have experienced extreme volatility during recent months, with many large swings occurring at the beginning or end of the trading period, when arbitrage is difficult or unavailable. Investors can avoid some steep premiums by buying and selling ultra short ETFs during periods when the underlying components are trading regularly and not subject to bans, halts, or other unusual trading events.

While the Sector Momentum Tracker does not currently track the ProShares sector ultra short funds, the ProShares Short S&P 500 (NYSEARCA:SH) is a top holding in the ETF Sector Momentum Portfolio. As of November 26, SH had garnered a 48.59% return year to date, contributing to the portfolio’s outperformance versus the Dow year to date. The Sector Momentum Tracker International ETF Portfolio includes the ProShares Short Emerging Market fund, which is up 45.26% year to date. The Sector Momentum Tracker will continue to add additional strategies and ETFs to our tracking system as they establish the volume and fundamental track record necessary for inclusion.

Ultra Sector ProShares (200 percent exposure)
Ultra Basic Materials (NYSEARCA:UYM)
Ultra Consumer Goods (NYSEARCA:UGE)
Ultra Consumer Services (NYSEARCA:UCC)
Ultra Financials (NYSEARCA:UYG)
Ultra Health Care (NYSEARCA:RXL)
Ultra Industrials (NYSEARCA:UXI)
Ultra Oil & Gas (NYSEARCA:DIG)
Ultra Real Estate (NYSEARCA:URE)
Ultra Semiconductors (NYSEARCA:USD)
Ultra Technology (NYSEARCA:ROM)
Ultra Utilities (NYSEARCA:UPW)

UltraShort Sector ProShares (-200 percent exposure)
UltraShort Basic Materials (SMN)
UltraShort Consumer Goods (NYSEARCA:SZK)
UltraShort Consumer Services (NYSEARCA:SCC)
UltraShort Financials (SKF)
UltraShort Health Care (NYSEARCA:RXD)
UltraShort Industrials (NYSEARCA:SIJ)
UltraShort Oil & Gas (DUG)
UltraShort Real Estate (SRS)
UltraShort Semiconductors (NYSEARCA:SSG)
UltraShort Technology (NYSEARCA:REW)
UltraShort Utilities (NYSEARCA:SDP)

Source: Investors Turn to UltraShort Funds to Beat the Bear