Proshares and Rydex are ETF providers that offer Inverse or double inverse funds.  The short ETF’s offer a convenient way for investors to short the market, or individual sectors of the market.  And both of them have double inverse financial ETF’s that have serious implications due to the SEC ban on short selling financials.  Proshares release a short statement on their website this morning related to the uncertainty:

Due to the emergency action announced by the Securities and Exchange Commission on September 18, 2008, temporarily prohibiting short sales of shares of certain financial companies, Short Financials ProShares (SEF) and UltraShort Financials ProShares (SKF) are not expected to accept orders from Authorized Participants to create shares until further notice.  Unless notified otherwise, shares will be available for redemption by Authorized Participants as normal. The shares of these ProShares are expected to trade in the financial markets. As disclosed in the prospectus, ProShares may at times trade at prices that are not in line with their intraday indicative values.

The SKF got absolutely hammered last Thursday in anticipation (SEC LEAK ANYONE??) of the short sale ban, and again on Friday when the ban was officially announced.


So what does all this mean for SKF and other ultra short investors?

The proshares prospectus clearly outlines their method of obtaining double exposure to the inverses.  They do not actually short the market.  Instead, they use multiple financial instruments, in an attempt to mimic the inverse performance of the underlying.  Per the prospectus, those instruments are:

  • Futures contracts and options on futures contracts
  • Swap agreements -  In a standard “swap” transaction, two parties agree to exchange the returns (or differentials in rates of return) earned or realized on particular predetermined investments or instruments.  The Funds are subject to credit or counterparty risk on the amount each Fund expects to receive from swap agreement counterparties. A swap counterparty default on its payment obligation to a Fund may cause the value of the Fund to decrease.
  • Forward contracts - two-party contracts entered into with dealers or financial institutions where a purchase or sale of a specific quantity of a commodity, security, foreign currency or other financial instrument is agreed upon at a set price, with delivery and settlement at a specified future date.”
  • Options on securities and Stock indexes and investments covering such positions

Proshares does not disclose the specifics of which of the above instruments they utilize at any given time to seek their double inverse returns.  My personal hunch tells me that most or all of the double inverse returns were coming directly from the two party counterparty swaps - at least until the SEC short sale ban last Thursday anyway.  The scenario is usually pretty simple.  Proshares would agree to pay a fixed amount of interest in exchange for a counterparty paying the return on an inverse index.  It is the counterparties, and not proshares, that actually does the shorting of the market or index.  And the counterparty risk associated with proshares ETF’s is the risk that these counterparties will become insolvent and not be able to pay the agreed upon inverse returns.

After the collapse of Bear Sterns, there was significant speculation around proshares, and whether they had any exposure to Bear Sterns as a counterparty.  Proshares in that case did come forth with additional details on their counterparties.  They still would not state clearly who their swap counterparties were, but they at least admitted that Bear Sterns was NOT one of them.

With the ban on short selling, the landscape and risk exposure of proshares inverse ETF’s changes completely.  Counterparty risk is still a concern on existing swap contracts, but by far the biggest counterparty risk is the US Government, and their under analyzed short sale ban. In the new environment, it does not really matter who the proshares swap counterparties are.  If those counterparties are unable to short the market, they have two choices, and neither of them are good for proshares:

  • Discontinue counterparty swap agreements with proshares
  • Assume near infinite, and unhedged risk (agree to pay inverse returns, but don’t short the market to hedge those risks)

In all liklihood, the proshares inverse funds will continue to exist in the short term, but the mechanisms they use to achieve their results will significantly change, and the risks to shareholders will go up as well.  Don’t expect full disclosure on what changes proshares implements, but it will likely be to utilize more options and futures and a lot less third party swap arrangements.  But with the spreads on options and futures increasing significantly over the last few days, it will be increasingly more difficult for proshares to come close to the desired performance.  The proshares prospectus explicityly lists correlation risk, but in the new landscape, that correlation risk could become much more significant.