There When You Need Them

Inverse mutual funds and ETFs are, in theory, useful alternatives investors can use in difficult times. But not always.

Last week the SEC imposed new restrictions on short-selling of certain financial services stocks. This created problems for inverse funds that specialize in that sector. The 2X-leveraged ProShares UltraShort Financials (SKF) seems like an ideal trading vehicle for the current market. Unfortunately, the SEC action made it very difficult for the fund manager to continue tracking its index correctly. As a result, last Friday ProShares asked the exchanges to halt trading in SKF and its unleveraged sibling SEF. The fund sponsor then announced that it was suspending creation and redemption activity in these two ETFs. In other words, SKF and SEF are now operating much like closed-end mutual funds. The arbitrage mechanism that keeps ETFs from trading at a significant premium or discount to net asset value is no longer in effect for these two funds. You can still buy and sell them, but you may not get the results you expect.

It is not entirely clear how these funds work internally to deliver inverse performance results. It may not be so simple as just shorting the stocks of the underlying index; ProShares might rely on swaps, options, futures or other derivatives. Whatever financial instruments ProShares uses in SKF and SEF are apparently not working under the new short-selling restrictions. Rydex announced similar restrictions for its Rydex 2X Inverse S&P Select Sector SPDR Financials (RFN).

That said, it is important to note that the SEC is taking an expansive view of what constitutes a “financial” stock for the purpose of short-selling restrictions. The list includes companies like Ford (F), General Electric (GE), International Business Machines (IBM), and Medco Health (MHS). GE is potentially problematic because it constitutes 15% of the index tracked by another inverse ETF, ProShares UltraShort Industrials (SIJ). Even broad-based inverse funds are likely affected, since the stocks that can’t be shorted collectively account for a huge part of total market capitalization.

I suspect a comprehensive study would find that bid/ask spreads and index tracking error rose significantly for all inverse ETFs over the last week. Those that specialize in financial stocks were hit the hardest, but are by no means the only victims. This isn’t necessarily a reason to avoid those funds — but be aware that the price you get could represent a substantial premium or discount to the actual value of the shares.