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We have recently fielded several questions about ETF structures with enhanced leverage features.

The matter of ultrashort ETFs pricing has been a hot topic of conversation for the past two or three months as investors who purchased and held them realized returns that diverged significantly from the results they had anticipated. The common issue that many investors encountered was a misunderstanding of the actual mechanics of the products.

Ultrashort ETFs, such as TBT -the ProShares Long-Term Lehman Bond Index product that is used for the charts below, replicate a short position that is recalibrated daily rather than a static leveraged position in the underlying (which would not be possible to duplicate in this type of structure mathematically). As such, investors that have purchased the shares and held them have often been very disappointed as illustrated by the first chart below which illustrates the divergence in returns realized by a long term holder of the ETF vs. a static short in the underlying index. The increasing number of shareholders holding the ETF over multiple trading sessions has increased with volume since inception (see "OVERHANG" in the second chart on the first illustration panel).

The confusion over these structures has been compounded by the existence of active options for many, which has led some retail investors that regularly engage in buy-write strategies to buy ultrashort ETFs and sell call options against the position without fully understanding what they were buying and selling.

For intraday traders who are utilizing the ETF as it was intended, the returns have come in with a very close correlation to a leveraged short intra-day position in the underlying, as illustrated in the second illustration panel below. Since the trading-leverage drought started last year the ultrashort class of ETF has become a magnet for hedge funds employing short term strategies who have found leverage to be difficult to extract from their prime brokers.

Ultimately, it seems unlikely that an ETF will be introduced that can truly approximate the economic exposure of a static 2-to-1 leveraged short position given the inherent credit exposure assumed by the issuer of any such product in the event that the underlying investment declined by an amount greater than the value of the actual ETF. As such I would expect that sophisticated speculators looking for multi session exposures will probably prefer futures and options markets whenever available.

Andrew Barber