The Best ETF for 2007: ProShares Ultra S&P 500

One of the benefits of exchange-traded funds is that they have opened up new methods of investing to ordinary people. You can invest in various sectors of the U.S. stock markets or in particular countries throughout the world. You can buy ETFs that track the price of gold, silver, or foreign currencies. Financial institutions continue to come out with new ideas for ETFs that will keep broadening the choices investors have.

An interesting idea that some ETFs have used to attract investors involves offering the opportunity to multiply their returns on certain investments they wish to make. For example, the ProFunds Ultra S&P 500 ETF (AMEX: SSO) seeks a return that doubles the daily return of the S&P 500. If you're bullish on the market and believe the S&P 500 is going to rise, then buying the Ultra S&P 500 ETF is a way to try to magnify your gains.

How these funds work is relatively simple. As you'd expect from a fund that uses the S&P 500 as a reference point, the Ultra S&P 500 ETF owns shares of components of the index, such as ExxonMobil (NYSE: XOM), General Electric (NYSE: GE), and Citigroup (NYSE: C). However, to achieve doubled returns, the ETF uses a variety of leveraged investment techniques, including the use of index swaps and other derivatives. The basic idea is similar to investors who use margin accounts to buy twice as much stock as they have cash, borrowing on the purchased stock to finance the transaction.

If you read the prospectus (link opens a PDF) for the Ultra S&P 500 ETF, you'll notice that while the stated goal of the fund is to double the daily return of the S&P 500, that doesn't necessarily mean that if the S&P 500 rises 10% in a given year, the ETF's value will rise 20%. In an unusual display of candor, the prospectus directly states that the investment methods the ETF uses won't generally allow it to achieve double the return of the S&P 500 over longer periods of time. Specifically, the prospectus asserts that in trendless or flat markets, the ETF will provide a return less than double that of the S&P 500.

Since its inception in June 2006, the ETF has done a good job of meeting its objective, helped in large part by a stock market that has mostly gone straight up during that period. However, a similar traditional mutual fund with a longer history, the ProFunds UltraBull Fund (FUND: ULPIX), shows the potential dangers of using this method over long periods of time, since that fund hasn't even managed to match the S&P 500's return over the past five years, let alone double it. In addition, the added costs of using this method are substantial; the ETF's 0.95% expense ratio compares poorly with the 0.1% expenses of index-tracking ETFs like the SPDR Trust (AMEX: SPY). Leverage is as much a potential pitfall for ETFs as it is with other investments.

On The Motley Fool's new CAPS service, which tracks the Fool community's thoughts on thousands of stocks and ETFs, everyone who has chosen the Ultra S&P 500 ETF believes that it will outperform the S&P 500. The majority of those who chose the ETF, however, view it as a short-term play, which is probably the best way for people to use this fund.

If you're interested in learning from others and sharing your stock market knowledge, CAPS is definitely for you. All you have to do to join Motley Fool CAPS is to sign up. And if you think the Ultra S&P 500 ETF is a solid idea for 2007, be sure to click "outperform." It won't cost you a thing and will give you the opportunity to match wits with some of the best investing minds out there.

Go here for the complete list of ETF contenders in our CAPS tournament. And for more information on exchange-traded funds, visit the Fool's ETF Center .

Fool contributor Dan Caplinger thinks the stock market is volatile enough without doubling its movements. He doesn't own shares of SSO or any of the companies mentioned in this article. The Fool's disclosure policy doubles your fun.