How Bear-Market ETFs Punished Investors

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As stocks suffered their worst single-year decline since 1931, one group of investors had a lot to celebrate: shareholders of so-called bear-market exchange-traded funds, whose shares go up when the market falls.

Yet as much bear-market ETF shareholders may appreciate finding gains when nearly everything else lost value last year, they may get a nasty surprise in the coming weeks as brokers release tax information for April filings.

A rich year for short ETFs
Bear-market funds have been around for a few years now. But after enduring long periods of gains for stocks, 2008 gave bearish investors a career performance. Just look at how well these ETFs did last year:

ETF	2008 Performance
UltraShort Industrials ProShares (SIJ)	80.2%
UltraShort Basic Materials ProShares (SMN)	60.6%
UltraShort Utilities ProShares (SDP)	40.8%
Rydex Inverse 2x Select Sector Energy (REC)	31.8%
Rydex Inverse 2x Select Sector Tech (RTW)	70.8%

Source: Morningstar, Rydex. Rydex returns reflect inception date of Jun. 10.

Of course, none of those returns should really come as a big shock. After all, stocks in those sectors took big hits during the year. Here's how some of the companies in those sectors did during 2008:

Stock	Sector	2008 Return
General Electric (NYSE: GE)	Industrials	(54%)
DuPont (NYSE: DD)	Basic Materials	(40.2%)
Dow Chemical (NYSE: DOW)	Basic Materials	(59.2%)
Exelon (NYSE: EXC)	Utilities	(29.9%)
ExxonMobil (NYSE: XOM)	Energy	(13.1%)
Microsoft (Nasdaq: MSFT)	Technology	(44.4%)
AT&T (NYSE: T)	Technology	(28%)

Source: Morningstar.

Moreover, Rydex timed its new bear market ETFs well, as the June inception just about nailed the high point of the energy boom.

Taking the tax hit
One benefit of ETFs is that they tend to be tax-efficient. Because most ETFs are designed to track certain indexes, they can limit portfolio turnover and therefore generate little if any capital gain. That's a major advantage over actively managed mutual funds, which can create tax liability for shareholders even in losing years like 2008.

Bear-market ETFs, however, proved to be nearly the opposite of tax-efficient. Each of the ProShares funds listed above had capital gains distribution of 38-44% of their value in 2008. The Rydex funds were even worse, with the energy ETF making an 87% distribution of capital gains.

Moreover, even some bear-market funds that didn't make money during 2008 created a tax nightmare for investors. Rydex's financial bear ETF made a 50% capital gains distribution despite having an overall loss of just over 5%.

Know what you own
What caused these tax problems for shareholders? The key lies in the investments the funds made. These particular bear-market funds are leveraged, seeking daily returns that are double the inverse of the underlying index. To achieve those goals, these funds typically use swaps and other derivatives.

In turn, because derivatives generally don't enjoy the same tax-deferral advantages that buying and holding stocks does, these ETFs generate substantial taxable income that must be passed through to shareholders. And the worst part of it is that you don't have to have owned the shares throughout the run-up in prices to owe the tax -- if you were a shareholder on the day the funds declared their capital gains distributions, you're the one on the hook.

As an investor, you need to understand everything about the investments you make. Even if you've heard that ETFs generally save you at tax time over mutual funds, you shouldn't count on that being true for the fund you're interested in. Especially with complicated financial innovation that gives you new ways to profit from market moves in any direction, being sure you're up to speed on how ETFs work will help you avoid any unpleasant surprises down the road.

For more on being smart with funds:

• Has the market hit bottom yet? Maybe not.
• The worst funds of 2008.
• Are bonds the answer for 2009?