Beware Low-Volume Tax Traps!

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By Sam Hopkins

Monday, December 22nd, 2008

How bout some inverse ETF shares in your stocking this Christmas?

After all, exchange traded funds that profit from market downside topped all the ETF rankings in 2008.

In fact, year-to-date returns have soared into triple digits for double-inverse funds like UltraShort Semiconductor ProShares (NYSE:SSG), which has gained 113% since January despite losing 37% in the month through December 22.

And all signs point to renewed momentum for inverse ETFs continuing well into 2009.

In the U.S. a new round of foreclosures is expected to gain steam starting in April, stemming from shaky option adjustable-rate mortgages (ARMs). The UltraShort Real Estate ETF (NYSE:SRS) aims to double the inverse of the Dow Jones U.S. Real Estate Index, setting it up for massive gains if option ARM defaults drive home prices further down.

Overseas, Toyota’s Sunday announcement of its first yearly operating loss since 1941 merely confirms the horrific earnings trend we’ve settled into. The already feeble Japanese economy is bracing for almost total economic stagnation, and the ProShares UltraShort MCSI Japan ETF (NYSE:EWV) stands to gain in that environment.

Now, trading volume is traditionally light during the winter holidays.

But judging by what little action there is as we turn the corner into 2009, we see a depressed investor base that is turning further away from long equity positions. The remaining market participants are reading the news and checking earnings announcements and guidance. They are taking advantage of a calculated downside benefit by betting against a basket of index stocks.

There’s plenty of room left for inverse ETFs to run. So now it’s time to differentiate among them and pick the best ways to profit from prolonged bearishness.

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Double Your Downside Profits With Short ETFs

In the case of the UltraShorts, leverage used by the ETF administrators gives you supercharged returns, doubling the opposite of the base index’s downside.

But even though they can be great ways to bet against an index you think will drop in value, exchange-traded funds that benefit from market downside require attentive management to avoid capital gains taxes.

You see, normal upside ETF shares are periodically subject to redemption by market makers. Those are ETF shareholders who redeem several thousand fund shares at once. If there is a gap between the net asset value (NAV) of the fund’s underlying shares and the fund’s own market value, a market maker will be eager to make that difference by setting up an in-kind redemption.

The spread between the NAV and the quoted value per ETF share becomes the market maker’s profit.

With inverse ETFs. though, the downside play means you’re using options and swaps, not equity, to profit. Then when the market maker wants to redeem ETF shares, options and swaps must be converted to cash. An in-kind redemption is not possible with short ETFs.

Rydex and the Short ETF Liquidity Trap

The Rydex Inverse 2x S&P Select Sector Energy ETF (NYSE:REC) logged short-term capital gains distributions of over 86% for the year ending December 9. High volatility and low volume set up a twin trap for REC, a young fund not yet able to absorb and diffuse major capital gains.

Rydex’s most prominent fund family is the CurrencyShares foreign exchange ETF series. In its short ETF segment, trading is so thin that market maker redemptions of several thousand shares have an augmented impact.

REC, for example, fetches volume of only 8,000 on average. Compare that to the ProShares UltraShort Oil & Gas ETF (NYSE:DUG), which moves 20 million shares per day!

ProShares are the most popular inverse ETFs, and their higher liquidity lets capital gains get spread out over longer periods.

Keep in mind that the ETF industry is maturing; there are nearly 700 now trading on U.S. exchanges, offering access to a breadth of stock and bond sectors and investment strategies.

ETFs are also developing their own comparative value as traded financial instruments, and volume risk is one aspect of differentiation. You may have noticed that on CNBC and other business television networks advertisements for ETFs have proliferated.

Well, that’s precisely because administrators are trying to avoid liquidity traps by getting more volume into their funds. Rydex won’t want to repeat its 2008 blooper; so, I’d expect more commercials for its fund products to come soon.

Be cautious, though, anytime a company or fund manager has to go on air to promote its virtues. Are they begging you to buy in?

The good news is that the beginning of the year may be the best time to try one of those adolescent ETFs.

Rydex’s year-end distributions are now in the past. Same goes for ProShares, whose capital gains were minimized by healthy volume.

Moving into a short ETF position at the beginning of 2009 will give you plenty of time to trade in and out before another distribution subjects you to a big cap-gains hit.

Regards,

Sam Hopkins

International Editor, Wealth Daily

P.S. — Bears are so dominant right now that playing downside ETFs almost seems like shooting fish in a barrel. But even on bullish days, Ian Cooper has led Options Trading Pit subscribers to successful short trades. Ian’s also got the upside angle, taking gains in those few companies that beat earnings expectations and get a positive pop. Individual options trades in OTP consistently beat even the best ETFs, and keep you away from tax traps. Check out Options Trading Pit today to learn more .

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