Tuesday, December 30, 2008

A Nasty ETF Surprise

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

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While studies generally indicate that ETFs are more tax efficient than mutual funds, there can be isolated exceptions and the ProShare family of short and ultrashort ETFs produced a truly shocking example on December 23rd. While ETF capital gains are usually minimal, in this case some of the funds distributions were closer to astronomical. Traders had no chance to adjust their portfolios to avoid the distributions either (and this was no accident), since the capital gains distribution was announced after the close and trading began ex-distribution the next morning. All holders of these ETFs, but especially short-term traders, will be getting a nasty tax bill because of ProShare's actions.

Ironically, the reason for the huge distributions are the success of the short and ultrashort ETFs. With the big drops in stocks this year, the ultrashort ETFs, which use margin to create a 200% short position, have been the biggest money makers by far. ETFs usually only incur capital gains when the indices or baskets of stocks they represent have bankruptcies, takeovers, or need to be rebalanced for other reasons. Apparently there was a lot more activity in these types or transactions in the short and ultrashort ETFs (all transactions get magnified in the ultrashort portfolios) in 2008 than in previous years.

The ProShae ETFs with the biggest distributions were:

1. $50.35 per share - SJL: Ultrashort Russell Midcap Value
2. $47.85 per share - SIJ: Ultrashort Industrials
3. $47.78 per share - SDK: Ultrashort Russell Midcap Growth
4 $42.35 per share - SSG: Ultrashort Semiconductors
5. $39.74 per share - SKK: Ultrashort Russell 2000 Growth

A full list can be found at: http://www.proshares.com/resources/news/36601289.html

If you were holding these ETFs in a non-taxable retirement account, capital gains distributions mean very little. Traders in taxable accounts however need to be careful in December. Anything ultrashort is not something that is meant to be a buy and hold position. By definition these are short term plays. You may want to take a holiday break from this type of ETF between Thanksgiving and New Years. New positions particularly should be avoided. The same advice will be good for the ultralong ETFs during a bull period.

NEXT: Pay attention to the First Four Trading Days of 2009

Daryl Montgomery
Organizer,New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.