From the October 2006 issue of Research Magazine • Subscribe!

October 1, 2006

Bull and Bear ETFs

Financial advisors often have to field clients' questions on whether it's a bull or bear market and, in either event, whether they should be buying or selling. Regardless of the answer given, one eternal truth will always live: There's money to be made in any kind of market.

To that end, ProShares Advisors in conjunction with the American Stock Exchange (Amex) recently introduced 12 exchange-traded funds (ETFs) that apply leverage and short positions to key stock indices. No matter whether equities are in bull or bear mode, the ProShares can be utilized to aggressively grow capital or to hedge portfolio positions. Ultimately, the decision to play either defense or offense is up to the advisor, depending on his or her outlook (and, of course, the client's needs).

Four of the new ETFs are designed to double the upside performance of the Dow Jones industrial average, Nasdaq 100, S&P 500 and S&P MidCap 400. Another four funds take a short or "bearish" approach by attempting to deliver opposite market performance on the same indices, while the remaining four funds aim to deliver highly concentrated shorts by doubling the associated benchmark's downside performance.

While leveraged and inverse performance has been a standard feature of closed-end and mutual fund products for some time, they are new to the ETF marketplace. In fact, ProShares is affiliated with ProFunds Group, which already offers mutual funds that have the same leveraged and short strategies. Now that the company is looking to make a big impact on how investors approach their ETF strategies, Research recently met with ProShares CEO Michael Sapir to discuss this and other related news.

Research: Why did ProFunds decide to enter the ETF business?

Sapir: We viewed ProShares as an opportunity to provide our indexing expertise to address unmet investor needs in the ETF market. ProShares are the only ETFs that provide built-in short or magnified exposure to market indices without the need for a margin account. For ETF investors, they make sophisticated strategies simpler to execute.

The fact that four of the ProShares use leverage is unique to ETFs. Many closed-end funds use leverage; how are the ProShares different? Also, how are the ProShares obtaining their leverage?

The major difference is that ProShares are indexed and closed-end funds generally are not. And while closed-end funds typically use leverage tactically, ProShares uses leverage to magnify the return of an index. On the long side, Ultra ProShares attempt to provide performance that doubles the daily performance of their underlying indices. On the short side, the UltraShort ProShares attempt to double the inverse of an index's daily performance. So, an investor can look at an index's daily return and know how the corresponding ProShares should have performed that day.

Also, with an ETF, differences between the net asset value (NAV) and the market price are usually small because authorized participants will attempt to arbitrage any premiums or discounts that exist. Closed-end funds don't have a mechanism to bring the market price of its shares back in line with its NAV.

To obtain leverage, ProShares may invest in equities and other financial instruments like futures contracts, swap agreements, options on futures contracts, forwards, etc.

Is this a better way for bears to play the market versus outright shorting?

We believe Short ProShares will make obtaining short exposure less complicated than selling short and may be the better way to go for many investors. First, to short-sell an individual security, you need to set up a margin account. With ProShares, you don't need a margin account, because the short exposure is built into an ETF package. Second, with a margin account, you can lose more than you invest. With ProShares, you can't lose more than the amount invested. Next, because ProShares are ETFs, you can use them in accounts where you couldn't necessarily sell short before -- like IRAs. Finally, there are other potential advantages in being able to easily follow your position like a stock and in the cost at which ProShares can obtain margin.

ProShares are essentially clones of already existing mutual funds managed by ProFunds. Since the ProShares have lower expense ratios, won't they cannibalize the mutual funds?

There are advantages to both ETFs and to mutual funds. There are some investors who are comfortable with the mutual fund format and others that want an ETF format, and some that will use both. Some investors may use our funds because they don't want to incur the transactional expense they may incur making ETF transactions, since we don't have any fees or limits on when our shareholders go into or leave one of our mutual funds. Others will value the ability to trade an ETF intraday. We are happy to provide our expertise in both formats.

Since the end of 2004, the number of sector ETFs has more than doubled. Are more investors opting for sector ETFs instead of sector mutual funds?

There are a lot of similar products competing against each other. We can't speak for other sector fund companies, but at ProFunds, we have actually seen increased interest in our sector funds. That's probably because they are different from your traditional sector mutual fund or sector ETF. The UltraSector ProFunds use leverage to seek 150 percent of the daily return of their underlying indices, and we also offer Inverse Sector ProFunds that seek to perform the opposite of daily index performance.

Continuing on the subject of sector ETFs, in some cases four or five funds are tracking the same industry sector. Are too many ETFs chasing the same assets?

It's going to be up to the marketplace to determine in the end whether there are too many sector ETFs focused on the same or similar slices of the economy. While there are thousands of mutual funds that focus on similar areas that seem to be able to survive today, there are not thousands of similar-indexed mutual funds being offered. Fortunately, we didn't confront this issue in coming out with ProShares. Our ETFs are the only ones that deliver built-in magnified and short exposure to indices and we believe they fill an important unserved need in the marketplace.

Most mutual fund companies are not in the ETF business. Will that change in the future?

We believe that mutual funds will be around for a long, long time and will serve the needs of many investors. At the same time, we believe that ETFs will continue to become a bigger part of the financial product landscape. One reason you don't see more mutual fund companies in the ETF business is that they aren't index fund managers. Right now, the only SEC-approved ETF structure is for index-based products. The Holy Grail is to create a structure that accommodates active managers' desire not to tip their hands to the world by disclosing their portfolio holdings on a real-time basis, but still keeps the SEC happy by allowing for arbitrage potential that sufficiently narrows the bid-ask spread. Even if such a structure were developed and got SEC approval, many mutual fund companies would also have to consider a monumental shift in their traditional distribution strategy in order to offer them.

It took a really long time for the ProShares to finally get the go-ahead from the SEC. What's the typical timetable for a new ETF product launch after it's filed for SEC registration? What causes delays?

Right now, we are simply happy to make ProShares available to investors. As far as the typical timetable, we're not sure there is one. You'd have to ask the SEC.

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