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Don't Fall on the Trap of Short ETFs

January 03, 2009

The best bet during big bear market has to be to short stocks. Many stocks lost over 90% since December 2007.

Because SEC put a lot of limitations on shorting stocks, many investors turned the eyes on short ETFs. Before buying into those short ETFs, you have to read their prospectus carefully. Otherwise, you may fall into the traps and lose big.

The followings are from our Commentary on December 7, 2008:

More on UltraShort ETF introduced by ProShare

In general those ETF is designed only for short term traders and is not good for long term investors who bet to profit from bear market. They are leveraged inverse short ETFs.

They perform daily 2X or even 3X inverse of their counterpart long ETF s. The key is the word "DAILY".

Let us to take a look of FXI and FXP.

FXI - The index fund, which tracks the performance of 25 blue-chip China ADRs from Hong Kong stock market.

FXP - It performs the daily double inverse of FXI.

You may check the performance of FXP against FXI .

FXI was down more than 50% from $ 65 in last December to $27.83 as of last Friday.
But FXP did not make any gain from the loss of FXI . Instead, it went down from $60 to $43.39 during the same period of time.

Let us explain how this could happen:

Support both FXI and FXP initially set at $10, FXI goes down to $8.00 next day and then returned to $10.00 the following day.

That is $10 -> $8 (-20%) -> $10 (+25%)

The fair value of FXP will be $10 -> $14 (+40%) -> $7 (-50%).

You can see, FXI did not change its value after two days but FXP lost 30%.

That is, those UltraShort ETFs are designed to lose value long term as long as its counterpart long ETF does not fall into zero, which is not possible for market indexes.

Therefore, if you short those UltraShort ETF's, you cannot lose. What you do is to keep adding your short position when the corresponding long ETF is flying.

To validate our observation, we have done a test on shorting DUG

DUG - UltraShort Oil&Gas Proshares ETF.

DUG performs the daily inverse of DIG - Ultra Long Oil&Gas ETF.

We all knew that oil price cannot be zero but it cannot go up forever either. In the foresee future, oil price will be traded in a range.

We all knew how oil prices were manipulated during 2007-2009. It went straight up from the low of $40's in January 2007 to a record high of $147 in July 2008 and then fell quickly to $30 and hit the bottom in February 2009.

The long term trend for DUG has to be down, down and down!!!

DUG was put into market by Proshare in February 2007.

The following is our very simple investment strategy:

We will short $1,000 of DUG on the first day of each month and never cover our position. Our test runs from 02/2007 to 12/2008 with a total investment of $23,000.00.

The following table showed the result:

The table was generated on December 15, 2008.

From the table we can see that during the 23 month span, we shorted a total of $23,000 DUG. It valued at $17,077.06 as of December 15, 2008. If you cover it all, the net profit will $5,805.94, a 25.24% return (a $7 commission has already been deducted for each trade).

Latest Update after it was published on Jan 3, 2009

As of July 24, 2009, DUG was at $16.26, another 46% haircut.



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