ETFs are gathering assets amid the market malaise.
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By John Gabriel | 01-13-09 | 02:30 PM | Email Article

As expected, the top-performing leveraged or inverse ETFs were all designed to produce double the inverse of their respective index's daily return. The relatively steady downturn in semiconductor demand and the technology sector in general caused by dwindling corporate profits and a weak business environment helped these UltraShort Proshares ETFs post strong gains. While it may be tempting to dabble in these aggressive products after seeing the eye-popping returns in the table below, we strongly urge investors to exercise extreme caution and understand what they're getting into. One aspect many individual investors likely overlooked this year was the relative tax inefficiency of these alternative products.

John Gabriel is a strategist on the passive funds research team for Morningstar and head of Canadian exchange-traded fund research.

A few days after we published an article discussing the huge capital gains distributions made this year by leveraged and inverse ETFs (namely Rydex), ProShares announced that it too would be making pretty significant capital gains distributions on 35 of the 76 ETFs it offers. (See the press release here.) We cannot stress enough that these aggressively leveraged products are not suitable as long-term investments. The reality is that it is extremely difficult--no matter how much of an expert one may be--to not only accurately call the price movement of a given asset from point A to point B, but to also project the path that it will take in the interim. Stay tuned for more details and discussion to come on this subject--in particular how the volatility drag of these daily compounding returns can eat away at long-term performance. ETFInvestor newsletter subscribers can learn more about this topic by checking out the soon-to-be-released January issue.

 Leveraged and Inverse ETFs
 

2008
% Return

2008 Cash
Inflows (MM)
AUM
(MM)
UltraShort Semiconductor ProShares 
112.65
(11.387) 23.365
UltraShort Technology ProShares 
97.83
7.259 58.573
UltraShort Russell MidCap Gr ProShares 
95.83
(11.647) 5.890
UltraShort Russell1000 Gr ProShares 
82.94
(16.032) 18.134
UltraShort Industrials ProShares 
80.20
(35.561) 45.129
* Data as of 12-31-2008.

The table below displays the top 10 ETFs, in terms of 2008 cash inflows. Judging by its constituents it would seem that there are many investors out there looking to gain exposure to the badly battered financial sector, emerging markets, and small-cap stocks. This makes sense as contrarian or longer-term-focused investors look to step up their exposure to the hardest-hit sectors. Otherwise, investors appear to be looking for general market exposure via the S&P 500. Interestingly,  SPDR Gold Shares  and  iShares Barclays TIPS Bond  also made the list. In our view, this says something about what investors believe could be the long-term inflationary ramifications of the loose monetary policy currently being employed by the Federal Reserve.

 Fund Flows
 

2008
% Return

2008 Cash
Inflows (MM)
AUM
(MM)
SPDRs 
-37.38
33,499.165 93,922.171
Financial Select Sector SPDR 
-55.21
9,117.615 7,791.799
iShares S&P 500 Index 
-36.94
5,052.260 15,652.552
Ultra Financials ProShares 
-85.19
5,002.495 2,412.270
iShares Russell 2000 Index 
-33.65
4,757.001 10,694.481
SPDR Gold Shares 
2.99
4,658.863 21,691.122
Ultra S&P 500 ProShares 
-67.79
4,493.606 3,545.485
iShares MSCI Emer Mkts Index 
-50.00
4,232.178 19,210.404
iShares Russell 1000 Index 
-37.57
3,672.500 5,724.536
iShares Barclays TIPS Bond 
-2.52
3,667.306 8,676.305
* Data as of 12-31-2008.

Looking ahead, we expect to see continued inflows for the ETF industry. As investors begin to regain their appetite for risk and look to dip their toes back into the market, we suspect that the rock-bottom pricing, unparalleled transparency, extreme tax efficiency, and intraday liquidity that the ETF structure offers will appeal to the masses. Stay tuned for updates on industry asset flows as well as where money is moving in and out of on an individual product basis. Click here to learn more about Morningstar Market Intelligence--a powerful tool that delivers comprehensive estimated cash flow and market share data for a variety of investment types across multiple geographical markets. 

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