These ETFs Bring Hedge-Fund Tactics to the Mainstream

While we consider most of that stuff to be a little too flavor-of-the-month for our tastes, not so for the ETFs launched by ProShares, including 22 that will hit the market tomorrow. Eight months after its initial launch, ProShares already has attracted more than $2 billion to a unique product lineup that allows investors to aggressively short or go long specific benchmarks. "We knew there was a demand for these products," says Michael Sapir, founder of ProShares. He tried for seven years to get the ETFs approved by the Securities and Exchange Commission.

ProShares is an offshoot of Sapir's ProFunds, the Bethesda, Md.-based mutual-fund company he started in 1997. The firm, which manages around $10 billion, has 57 funds, including 11 traditional index funds that track benchmarks like the S&P 500, Russell 2000 and Nasdaq 100. But what the company is really known for are its "Ultra" and "Inverse" funds. By employing a combination of futures and options, the Ultra funds try to return 200% of the daily performance of a given benchmark, while the Inverse funds will either try to match or double the opposite results of that same target. ProFunds was originally an also-ran in the business...that is, until its UltraOTC fund (UOPIX), which tracks the Nasdaq 100, beat that benchmark by 150% at the height of the tech boom.

Obviously, what followed wasn't pretty. But ProFunds — and the ProShares ETFs that are modeled on the same premise — aren't designed for the buy-and-hold crowd. "I think you could live a very happy life without them," says Morningstar's Dan Culloton. "You need to be a pretty sophisticated trader to be able to use them." Indeed, these funds are set up for active traders looking to get in and out of parts of the market quickly. ProFunds, for example, is one of the few fund families that doesn't levy a redemption fee, a tactic most competitors use to stop market timers. "It's a very different product," says Jeff Buetow, who keeps an eye on new ETF offerings as the chief investment officer of XTF, an ETF-only investment firm.

We usually shy away from such products. After all, do we really want you competing next to hedge funds and big institutions? That said, we do have a greater comfort level here because of the decade-long track record. And we do realize that some of you out there fancy yourself as active traders. If that's the case, we would suggest that these products only constitute a small portion of your portfolio. One tactic is to use them as a hedge against an aggressive bet in your portfolio. Or, if you think the market is due for a correction, you could purchase the UltraShort S&P 500 (SDS) as a way of making money in a down market.

Since both the ProShares and ProFunds families operate on the same theory, going with one over the other boils down to a simple detail: You can trade ETFs throughout the day, a point that should appeal to active investors. For now, the ProShares lineup consists of Ultra and Inverse products that follow benchmarks like the S&P 500, the S&P Small Cap 600, the Russell 2000 and the Nasdaq. The new ETFs that will come on the market tomorrow track 11 Dow Jones sectors like utilities, oil & gas, technology, basic materials and health care. International Ultra and Inverse ETFs will follow.

As always, though, there are alternatives. Those niche Dow Jones funds have competition from the Select SPDRs family of ETFs that divvy up the S&P 500 into similar industry slices. If your broker will execute the trade, you can short them. (But you can't go aggressively long.) The other alternative is to just avoid parts of the market you think are overheated instead of doing all this maneuvering to benefit from a down turn. After all, you incur a cost every time you enter or exit a fund. And as we all know, fees are the worst enemy of a well-constructed portfolio.