Tax Advantages of Inverse ETFs Not So Clear

by: SA Eli Hoffmann

Many market participants have found good reasons to capitalize on REIT weakness. There may be good reasons to short the sector, but one method mentioned by Alan Abelson in this week's Barron's may not be as advantageous as it suggests.

On June 9, Seeking Alpha noted that Barron's Andrew Bary had turned bearish on the apartment/commercial REIT sector. Tishman Speyer Group's recent $60.75/share takeout of apartment REIT Archstone Communities Trust (ASN), he noted, signalled an over-abundance of real-estate-seeking-capital. Archstone's yield is just 4.3% to apartment REIT's average of 5.1%, and 5.7% for general REITs. Consider that 6% interest on a $17.1 billion loan (somewhere in the neighborhood of $1B/year) is more than Archstone's 2007 operating income of $800 million.

After years of whopping returns, Morgan Stanley's MSCI REIT index is trending downwards:

MSCI REIT Index 17 06 2007

Joe Rosenberg, chief investment strategist at Loews, called Sam Zell's EOP sellout "one of the most timely sales in the history of his business." While Zell denied his sale indicates a sector top, Rosenberg advises listening to the age old adage, "Do as they do, not as they say."

On March 4, we covered a Barron's bearish piece by Jacqueline Doherty on apartment REIT AvalonBay Communities Inc. (NYSE:AVB). Barron's said insider selling and slowing FFO [funds from operations] could take shares from a (then) $131 to $110. On May 15, shares traded as low as $115, although they have since peeked back over $130 and currently trade at $129.50.

AvalonBay 17 06 2007 Chart

This week's guest columnist Kevin Duffy (yes, you too can write for Barron's) writes that more bells toll for U.S. markets "than at an Austrian downhill ski race":

With so many on Wall Street singing the same optimistic tune, is it time to get defensive and grab a chair before the music stops? Perhaps the adage by the late Humphrey Neill, the father of modern contrarian theory, applies here: "When everybody thinks alike, everyone is likely to be wrong."

Which raises the obvious question: How might one go about shorting this sector? One option, if your broker allows it, is to pick a particularly weak stock and short it. Then there are REIT exchange-traded funds [ETFs], which allow investors to go both short and long, while offering broad-based exposure to the sector instead of an individual stock. Even more cutting-edge, there are now short ETFs -- you buy the shares, and the ETF provider sells the securities. If stocks in the fund go down, your shares go up, and visa versa.

Alan Abelson's Up and Down Wall Street column this week suggests that inverse ETFs, aside from their novelty, may convey a potential tax benefit.

Abelson tells us of a chat with an old buddy who is "more than slightly antsy about the investment climate":

We were particularly struck, though, by the medium through which he chose to do his shorting: namely, the latest members of the exponentially growing population of exchange-traded funds, managed by an outfit called ProShares.

I.e. ProShares inverse lineup. It would be a technicality, but for one salient difference. Profits from regular short sales are always considered short-term capital gains, no matter how long you hold the position, and are taxed as ordinary income. But buy one of ProShares short funds, and you have "the possibility of gaining long-term capital-gains treatment." So says old buddy.

What he fails to note is that most of ProShares short offerings are UltraShorts, so named because they use futures and swaps to amplify their leverage. According to Matt Hougan at Index Universe, futures positions are marked-to-market at year-end and taxed 60% as long-term gains and 40% as short-term, while swaps are taxed as 100% short-term gains. His research indicates that ProShares relies almost exclusively on swaps to achieve its leverage.

ProShares UltraShort Real Estate (NYSEARCA:SRS), seemingly the unnamed ETF to which Abelson's buddy aludes (it's the only short real estate ETF in their portfolio), doesn't come in a non-ultra version. So if you're looking to short REITs using ETFs, your tax savings may be little-to-none, depending on exactly how ProShares achieves its short position.

ProShares UltraShort Real Estate 18 06 2007

ProShares six straight-up short ETFs are: ProShares Short QQQ (NYSEARCA:PSQ), ProShares Short Dow30 (NYSEARCA:DOG), ProShares Short S&P500 (NYSEARCA:SH), ProShares Short MidCap400 (NYSEARCA:MYY), ProShares Short SmallCap600 (NYSEARCA:SBB), and ProShares ShortRussell2000 (NYSEARCA:RWM).

The rest of its short lineup is ultra-short, offering leveraged exposure to MarketCap indexes, growth/value indexes, and sector indexes (see below).

Always remember, caveat emptor... or is that caveat venditor?

ProShares Short MarketCap 17 6 07

ProShares Short Style 17 6 07

ProShares Short Sector 17 6 07