From the November 2008 issue of Research Magazine • Subscribe!

Bad News Inspiring Bearish ETFs

The financial crisis that accelerated when Lehman Brothers Holdings (LEH) was pushed into bankruptcy protection sent chills through stock markets around the world. Exchange-traded funds (ETFs) tracking key equity benchmarks like the Dow Industrials, Nasdaq and S&P 500 continued their downward slide.

But not all is doom and gloom because there's a bull market happening right now in bear market ETFs.

Bear market funds are designed to provide opposite performance of whatever index benchmark they follow. If stocks fall, bear or inverse ETFs are built to increase in value. Conversely when stocks rise, inverse ETFs fall in value.

ProShares are the largest family of bear market ETFs. Among the firm's 40 inverse performing funds, all but eight are posting positive year-to-date performance. This sort of dominant performance gives you an idea of just how poorly global equity markets are performing.

The ProShares Short Dow 30 (DOG), which aims to deliver the opposite daily performance of the Dow Jones Industrial Average, has gained 12.6 percent on the year.

Some of this year's biggest gainers are inverse ETFs that use leverage. The ProShares UltraShort MSCI EAFE (EFU) is ahead by 53.7 percent since the beginning of the year. The MSCI EAFE is a popular benchmark of international stocks, but its recent performance has really soured.

Even though media attention has been fixated on the horrific performance of financial stocks, other industry sectors like semiconductors have gotten hammered. As a result, the ProShares UltraShort Semiconductor (SSG) has gained 50.3 percent on the year.

Despite the impressive gains made by bear market ETFs, profits can evaporate just as quickly as they arrive. Keep this in mind.

For that reason, I have two general rules for using bear ETFs I'd like to share with you.

First Rule: Only use bear ETFs with money you can afford to lose, because you probably will.

Second Rule: Only use bear ETFs after you've laid the foundation of your investments to a broadly diversified mix of low-cost index funds and ETFs.

Lastly, ProShares aren't the only bear market ETFs. Rydex Investments offers funds that go opposite the small-cap Russell 2000 (RRZ), S&P MidCap 400 (RMS) and the S&P 500 (RSW).

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Ron DeLegge is the San Diego-based editor of www.etfguide.com.

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