WATCH YOUR TAX LIABILITIES ON SHORT ETF’s

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March 25, 2009 12:45pm ETF BASIC NEWS

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There’s an undeniable appeal to investments that promise to make money when the market drops. Perhaps that’s why so-called short ETFs have attracted $9 billion. When the market goes down, these exchange-traded funds are supposed to rise. But in the recent crash, some investors who used the ETFs to bet against the market were shocked to find they lost money anyway — and took a nasty tax hit, too.

Short ETFs — also called bear or inverse — use complicated futures and derivatives to provide the opposite return (or even two or three times the opposite return) of an index. It can be tempting: Who doesn’t want to be up 30 percent when the market is down 10 percent?

Not so fast. Last year, when most major indexes fell by double digits, several bear-market ETFs also lost big. The MSCI Emerging Markets index fell 54 percent in 2008, so you might think the double-short ETF that tracks it would have gained 108 percent. Wrong: It lost 25 percent. The Dow Jones U.S.

Real Estate index fell 43 percent last year; ProShares’ double-short real estate ETF fell 50 percent.

Don’t blame us, says ProShares Chairman Michael Sapir. “It’s the math.” The funds match the opposite returns of an index on any given day, but the results compound daily. So even if the index is down over, say, a two-week period, an investor who held on through daily ups and downs could lose money. That’s why Sapir and other ETF execs say their products are for sophisticated investors and daily traders. “Joe Buy-and-Hold? Please don’t invest in our funds,” says Direxion Funds’ Marketing Director Andy O’Rourke.

“They’re not appropriate.”

Even worse, some of the bear ETFs that did make money last year came with a big tax bill. For most investors, one of the benefits of ETFs is their tax efficiency. But because of the leverage used in these ETFs, investors are often saddled with higher short-term capital gains taxes, even if they don’t sell any shares. Ugh, says Morningstar strategist Paul Justice. If you’re still tempted, he says, trade the short ETFs daily. Or find a bear mutual fund that involves less complicated math.

Source: www.smartmoney.com



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