January 8th at 1:00pm by Tom Lydon

Short and leveraged exchange traded funds (ETFs) were the subject of much discussion in 2008, owing in large part to record market volatility. But sometimes their inner workings can be a bit of a mystery to investors.

These types of funds allow investors the opportunity to hedge their portfolios, even in down markets, making them especially attractive in tough years. They were among the top performers in 2008, with 19 of the top 20 being of the short and ultra short variety. Their popularity last year made them the subject of derision, most notably by Jim Cramer .

But leveraged ETFs are a different animal than your average fund. When it comes to them, however, it’s caveat emptor. No matter where you choose to invest your money, it’s always wise to be aware of both the pros and cons. Not all products are right for all investors. These funds certainly do have applications for investors who are looking to hedge positions or make money in down markets on a short-term basis. They arent meant for a buy-and-hold strategy.

Leveraged ETFs have long been noted for their higher volatility, since they maximize market movements in either direction. In a year such as the one we just saw, the volatility even in some plain vanilla ETFs was stunning never mind those that magnified the market’s movements by double or triple.

However, long and short ETFs can have tracking error. On a day-to-day basis, the performance isnt 100% perfect, but its fairly close. However, over the long-term, there can be bigger differences between long ETFs and their short counterparts.

• Assume the S&P gains 4% on Monday. The ProShares UltraShort S&P 500 (SDS ) will fall 8%.
• On Tuesday, the S&P falls 3.8% to end the two-day period flat. SDS will rise by 7.6%, leaving it down 1% after the same two-day period.

So, even though the S&P is flat in this scenario, the SDS will have a 1% loss in just two trading days. The phenomenon is that when you fall by a certain percentage, it takes a bigger gain to get back even. A loss of 50% will require a 100% gain to get back even. Over time, 1% here and there adds up.

In short, on any given day, these funds do what theyre supposed to, but over time internal compounding can have a positive or negative effect. To hear more about short and leveraged ETFs, listen to our most recent podcast .

A long fund, such as the Ultra S&P 500, seeks to double the returns of the S&P 500. That means when the index goes up, your returns will double that.

If a fund looking to double the S&P has $100, then the fund will contain tools to give it roughly $200 exposure to the S&P.

And that exposure is gotten in much the same way: buying baskets of stocks that might give dollar-for-dollar exposure, along with futures contracts and swaps, which are inherently leveraged. This means that if you put down $1, you will get $1of exposure.

A short fund, such as the shorts or two beta, seek to provide either the opposite of the index, or twice the opposite. They can be a way to capitalize when the markets are heading south.

Shorts work in a similar way, with one key difference: no long positions are bought. Short funds also don’t short stocks. Instead, they primarily short futures contracts and swap agreements.

As it’s been said before, just be sure to use these products with caution as much as they have potential to generate super-sized returns, they can leave a super-sized ding in your portfolio, too.

For more information on leveraged funds. watch this video over that The Wall Street Journal. as well.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.