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By Michael Rawson, CFA

With nearly 30 million shares and $300 million dollars traded daily, ProShares UltraShort S&P 500 (NYSEARCA:SDS) is one of the most heavily traded exchange-traded funds. But as a leveraged and inverse fund, it does not have the same benefits as plain-vanilla ETFs. It's best left to the short-term hedgers or speculators.

The fund attempts to provide twice the daily inverse return of the S&P 500. Leveraged funds are expensive and extremely risky, so they are best left to speculative traders or hedgers who have the desire to monitor and trade their positions daily. While it may be tempting to use a leveraged or inverse exchange-traded fund to capitalize on an investing idea or as a hedge, investors would probably be better served by using unleveraged products or adjusting their asset allocation. The mathematics of compound interest makes volatility a hidden cost to this fund beyond the already high 0.89% expense ratio. The SEC is examining the need for additional investor protections for leveraged and inverse exchange-traded funds and has put a temporary halt to the issuance of new derivatives-based ETFs. In addition, FINRA has cautioned its broker members on the sale of leveraged ETFs.

On the positive side, the 0.89% fee this fund charges is less than the borrowing cost, so it can be a less expensive way to short the market. Another advantage to placing a bearish bet with this ETF as opposed to shorting individual stocks or bullish ETFs is that you cannot lose more than your original investment, although if you hold it long enough without rebalancing, you may lose your entire investment.

Compound Interest and Compound Volatility
Leverage vastly increases the negative impact of volatility on returns. To see why, imagine that the index gains 5% per day for five straight days and then loses 5% per day for the next five days. At the end of this period, the compound return on the index is negative 1%. Despite the fact that the arithmetic sum of these returns is zero, the volatility drag results in a slight loss. This ETF, which would have had daily movements of negative or positive 10% each day, would have lost 5%, while its 2 times bull cousin ProShares Ultra S&P500 (NYSEARCA:SSO) would also have lost 5%.

As a real-world illustration, for the five years ended February 2012, SDS was down 19.2%, and SSO was down 6.6%, though the S&P 500 Index was up 1.6%. So, over periods longer than one day, a constant holding in leveraged bull and bear funds can both have negative compound returns due to the amplified volatility drag. Avoiding these counterintuitive results requires daily trading. More information on how leverage and inverse ETFs can kill your portfolio can be found here.

Another problem with this fund arises from the index swaps used to produce the desired returns on leveraged and short index ETFs, which are always taxed at short-term capital gains rates. Because ETFs are taxed on a look-through basis, where investors pay what they would have if they'd directly held the underlying securities, any investor who sells these funds for a gain will face a hefty tax bite even if they were held for more than a year.

Don't Short an Undervalued Market
The S&P 500 returned 4.2% over the past decade on an annualized basis. That anemic return came with incredible ups and downs, while safer bonds offered a 5.7% return with substantially less volatility over the same period. At this point, the outlook for stocks has improved. The S&P 500 in early 2012 is trading at the same level it hit in 1999. Yet the underlying companies have grown considerably over the trailing decade. Profits in 2012 are expected to reach record levels. The dividend yield on the S&P 500 is higher than the yield on 10-year Treasury bonds, a rare occurrence that bodes well for stocks. Morningstar analysts rate nearly every stock in the index and assign fair value targets based on discounted cash flow models. They see the market as undervalued, with the stocks in this portfolio trading at a price/fair value of about 0.91. Stocks also look attractive on a price/earnings basis, trading at about 12 times forward earnings. However, stocks look less attractive based on the cyclically adjusted price/earnings ratio, which uses 10-year average earnings to smooth out business cycle fluctuations.

Over the past five years, the S&P 500 gained about 1.6% through February 2012. However, this fund, which attempts to deliver the inverse of the daily return, lost 19.2%. That large discrepancy results from the diabolical effect that volatility can have on returns. We would only recommend shorting the market if it were substantially overvalued, and even in that case, it would be preferable to trim long exposure before using an inverse fund. Given the fact that we see elevated volatility in the markets going forward, we would not recommend this fund to investors at this time.

Derivatives Under the Hood
ProShares UltraShort S&P 500 seeks to provide twice the opposite of the S&P 500 Index's daily return and may do so through the purchase of options, futures, index swaps, and other derivatives. In practice, this fund holds virtually all of its assets in cash, while entering into short-term index swaps that provide the daily desired return. Index swap derivatives are contracts in which one party, or the fund, promises to pay the other a fixed interest rate on a given notional amount in return for the other party promising to pay the return on an agreed-upon index for that same notional amount. Because the ProShares funds hold on to their cash collateral for the index swaps, their principal faces no counterparty risk. The only danger from banks and other financial counterparties collapsing is that the fund may lose part of its promised return.

Complex Funds Usually Cost More
ProShares UltraShort S&P 500 charges a fee of 0.89% annually, which is costly for an ETF but not much pricier than rival inverse ETFs.

There are very few good substitutes for the extremely bearish exposure of this fund. Guggenheim Inverse 2x S&P 500 (NYSEARCA:RSW) also aims to provide double the daily inverse return of the S&P 500 and carries a smaller expense ratio of 0.71%. However, it has far fewer assets and a much lower trading volume, so market-impact costs from trading could be higher than the difference in expense ratios over the fairly short periods that most investors would be holding this fund. Direxion Daily Large Cap Bear 3X Shares (BGZ) offers 3 times leverage at a 1.02% expense ratio with decent liquidity, but it covers the broader Russell 1000 Index.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: A Bearish Leveraged ETF Best Left To Short-Term Traders