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June 9, 2006 4:46 pm

Leveraged exchange-traded funds for bigger bets

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ProFunds Advisors plans to launch the first leveraged exchange-traded funds that would enable bullish investors to make big bets on traditional stock indices while allowing bearish investors to make money during market downturns.

The boutique money manager recently filed an updated prospectus with the Securities and Exchange Commission for 12 new ETFs – baskets of securities that are designed to track indices and trade like stocks – that seek to provide daily returns twice that of bellwether stock indices.

“The best way to think about these things is that they are using financial derivatives – predominantly futures – to get exaggerated returns in a given index,” says Dan Culloton, a lead ETF analyst at Morningstar, the investment research company. “Essentially, they are putting up more money than is actually there to accelerate returns.”

According to the SEC filing, ProFunds hopes to market four bullish “ultra” funds that aim to produce returns double their under­lying indices: the Standard & Poor’s 500 stock index, the Dow Jones Industrial Average, the Nasdaq 100, and the S&P MidCap 400 index. For example, if the Dow increased 1 per cent in a day, the corresponding ProFunds ETF would give investors a 2 per cent return.

The Maryland-based mutual fund group will also unveil eight bearish funds, four of which aim to produce inverse returns to those four indices. So if the Dow drops 1 per cent in a day, then the inverse ETF aims for a positive 1 per cent return. The other four proposed ETFs are “ultra” funds that aim to produce double inverse returns – or twice the opposite of the market’s return. Accordingly, if the market dipped 2 per cent, the fund would gain 4 per cent.

David Haywood, director of alternative investment research at Financial Research Corporation (FRC), the Boston-based data company, says this is a natural step for ProFunds, which has already carved out a niche in the fund management industry by providing mutual funds with leveraged short and long attributes.

“It is very logical move for ProFunds,” he says. “These proposed ETFs emulate existing ProFunds mutual funds.” The big difference is that ETFs are priced like stocks and traded throughout the day, enabling investors to dash in and out of the market.

Industry observers predict that ProFunds’ new leveraged ETF family will spur other mutual fund companies to provide similar products. For instance, Rydex Investments, a Maryland-based asset management company and ProFunds’ chief rival, has applied to the SEC for permission to market leveraged ETFs. “Once the SEC grants an order to ProFunds, you can count on it granting one to Rydex – probably within the next three months,” says one insider.

“Product development in ETFs is happening at a feverish pace,” says Haywood. “Enhanced and sub-sector products are coming to market all the time. Each ETF that is coming out right now seems to break new ground.”

In recent years, ETFs have rocketed in popularity. Net flows this year alone total more than $13bn. And assets within ETFs have risen from $66bn in 2000 to $341bn today, according to FRC.

It is unclear precisely when the proposed funds will launch, although industry observers expect to see them on the market before the end of the year. A spokesman for ProFunds Advisors declined to comment because the firm is in its quiet period, a 25-day span where SEC prohibits it from promoting its funds ahead of their launch.

The question is: who will buy these new funds? ETFs in general tend to be favoured by investors who want the ability to trade throughout the day. ETFs are also becoming favourites of hedge funds and day traders who use sophisticated trading strategies and like to pull the trigger frequently.

Culloton expects institutional investors to use these leveraged ETFs as part of a tactical strategy. “I can also see financial advisors using them as a hedge,” he says. “Say they’re generally long on the S&P, they might use a short ETF on part of their portfolio to hedge against short-term falls.”

But, he says, these proposed funds aren’t for everyone. “[Investors] have to understand what they are getting into and compare that with their investment goals,” he says. “In most cases they will realise that this is probably not for them. In general, it’s more difficult to use these without tripping up.”

Haywood concurs. “The average investor needs to be careful because of the risks associated,” he says. “Make one bad bet on the market and you lose a lot quicker. I describe these types of products as ‘juiced’.”

Costs are another unknown. ETFs tend to have lower expenses than actively managed funds and many traditional index funds but they often have big commissions attached to buying and selling.

Culloton says that these new ETFs could be pricey. “The trend in the ETF industry is to offer more specialised funds at a higher price point than straight index funds,” he says. “The argument is that it’s something different, it’s more complicated and it adds value.”

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