ProShares Short Emerging Markets ETF: Demand Continues to Grow

While the U.S. economy is sinking beneath the weight of the recent financial crisis, the heaviest blows have been dealt on an international scale. As a global financial slowdown is coupled with a decrease in demand for commodities, emerging markets are the hardest hit. The ProShares Short MSCI Emerging Markets ETF (EUM) has helped some investors capitalize on this weakness by tracking the inverse of the battered MSCI emerging stock index. While market and regulatory factors make short ETF strategies like EUM very risky as stand-alone investments, products like these can be extremely useful as part of a larger investment strategy.

With the bailout plan on the books, investors anxiously looked abroad on October 6. By the time U.S. markets had hit their lows, emerging economies had suffered the worst of the day’s trading. The MSCI emerging stock index fell 10% in early trading, marking a two-year low. So far in 2008, the index has fallen more than 46%. While the U.S. financial crisis has played a role in this decline, the emerging market slide is also tied to weakened commodity prices, inflation, growing strength of the dollar and geopolitical concerns.

The increased demand for a short emerging markets strategy pushed EUM to the top of our International Momentum Table. Since we added it to our international rankings in early September, EUM has held the No. 1 position, followed closely by the ProShares Short MSCI EAFE (EFZ) fund. On October 1, we added EUM to the International Portfolio holdings for the second time this year. If emerging markets continue to weaken, EUM could help to provide returns while hedging current long portfolio holdings.

EUM is designed to return the opposite of its underlying index—so bad news for emerging markets is good news for EUM. As of October 2, EUM had risen 40.82% year to date. By purchasing EUM, you synthetically short the countries that make up the MSCI emerging market index, including Ukraine, China, Hungary, Vietnam and Russia. From July to September, the outflows from emerging market bond and equity funds and exchange-traded funds reached almost $30 billion—the highest level since 1995.

The ProShares short and ultra-short emerging markets funds, EUM and EEV, were launched late last year when many emerging markets investors still felt invincible. The MSCI emerging markets index has delivered returns of more than 30% in the last several years, only to be greeted by an even sharper decline in 2008. As investors scrambled to find ways to hedge existing exposure and bet against the trend, EUM gained in size and popularity. On Monday, October 6, as emerging markets tumbled, EUM’s volume was 266,393 shares—more than five times its three-month average trading volume of 48,801 shares a day.

The recent flight from emerging markets illustrates a shift in the global economy. David Lubin, emerging market strategist at Citigroup, noted that “emerging market asset prices rose strongly in a world of rapid growth and high commodity prices, creating something like a virtuous circle.” Recent gains in the dollar have helped to break this cycle and boost funds like EUM. “The strength of the dollar has put emerging economies’ currencies under pressure just at the point where a rise in global risk aversion is pushing investors away from exposure to developing countries,” Lubin added.

According to EPFR Global, this push caused investors to take $1 billion out of equity and fixed income funds on September 8, and this amount could increase as the U.S. financial crisis intensifies. While some investors will continue to withdraw these funds from the marketplace, others will seek alternatives like EUM to bet against the market and increase gains. EUM has also helped investors hedge some of their existing exposure to emerging markets accumulated during the boom from 2004-2007.

As fear reaches fever pitch, the demand for short ETF strategies has caused some dislocation in the funds’ pricing. The combination of primitive, volatile emerging markets abroad and increased short sale regulation at home has driven many investors to seek out short ETF alternatives. International ETFs often trade at noticeable discounts and premiums to NAV, and increased demand caused by the recent crisis has driven EUM to trade at unusual premiums. Since early August, EUM has consistently traded at a premium to NAV—a margin that grew to as much as 1.88% on September 30. Many investors, however, find this a small price to pay when dealing with inaccessible markets in an unpredictable global economy.

Trading short ETFs is a complicated and risky strategy that is safest when used in conjunction with a larger portfolio model. International ETFs expose investors to different risks than domestic funds do, and these risks may only be intensified with a short or ultra-short strategy. Demand for these strategies, however, will only increase if the global economy continues to weaken—creating liquidity, accessibility and an understanding of short ETFs.

Comments

[Eric Peterson:]

Interesting that this article appears on a day that EEV lost 37%. Maybe a record one-day loss for EEV?

2008 Oct 13 03:51 PM