The decision by ProShares and Rydex to stop creating new shares of their short financial ETFs shouldn’t affect most individual investors and can actually be viewed as a sign of maturity and confidence in the ETF Industry. Here’s why:
1. Cutting off new money is a long-established practice by conscientious fund managers. When investment opportunities dry up, good managers stop taking new money. That’s what happened in this case. A tremendous increase in volatility of the financial sector was creating enormous demand for short ETFs. Putting that money to work was getting harder to do and the ban on short selling wouldn’t make it any easier.
Rather than take new money and scramble to establish positions at any cost, both fund managers made the judicious decision to close the window to new funds. The reason we don’t see this more often in the ETF world is that, in most cases, Authorized Participants (APs) must bring shares of the portfolio companies to the table in order for the manager to create a new ETF share. In this case, all APs had to bring to the table was cash.
2. Individual investors should have little or no exposure to short financial ETFs. Short and UltraShort sector ETFs are terrific tools for sculpting and shaping a portfolio to optimize risk and return. However, like any good power tool, they can be dangerous weapons if used for the wrong purpose.
Another watchout is the fact that these ETFs are not designed to be held for long periods of time. You can figure this out pretty quickly by reading the first page of the ProShares prospectus for SEF – “The Funds do not seek to achieve their stated investment objective over a period of time greater than one day.”
In other words, they target single day performance, so tracking error will likely increase if held for periods longer than even one day.
3. Redemptions are unaffected and market prices are at or near NAV. Both fund managers stated that redemptions from APs will go on as normal. Although Amex temporarily halted trading of SEK and SKF on September 19 pending the news from ProShares, tracking error (the difference between the market price and the net asset value of an ETF) quickly returned to normal. As of end of the trading day on September 24, SEF and RFN actually closed slightly below NAV.
Also, kudos to the ProShares team for putting together a comprehensive set of FAQs that should answer many of your questions.