These 5 Underdogs Are No Dogs

Short-sellers and hedge funds, though sometimes shadowy, are sometimes seen as the smartest guys in the room. They did their homework and will bet their capital against the crowd. And even though theirs is not the most popular way to go, the rewards can be quite lucrative.

On Motley Fool CAPS, we have our own brand of leading analysts who found the chinks in a company's armor and correctly called the fall. "Underdogs" are investors who earned 100 or more CAPS points correctly predicting that one or more stocks would underperform the market.

Let's look at some of the recent calls these All-Star investors have made. Yet just as hedge fund operators don't always go short, we're going to look at recent Underdog picks no matter which way they've been called.

Going short is risky, since not every short sale goes as planned. Stock prices can be irrational for longer than you have money to stay in the game. So don't use this as a list of stocks to sell or buy, but rather as the launching pad for further research.

Underdogs still wag their tails
The evidence seems to be mounting that if you want to be hedging your bets on markets or countries, ultra-short positions may not be the way to go about it. The way they're designed, you may open yourself up to excess risk of loss if you use ultra-short instruments for anything but day trading.

For example, the ProShares UltraShort FTSE/Xinhua China25 seeks results that are twice the inverse of the daily performance of its index. But it's not buying or shorting the underlying stocks in the index, which include notable names such as PetroChina (NYSE:PTR) and China Mobile (NYSE:CHL). Instead, it uses complex financial instruments such as options, swaps, and futures to achieve the negative return. So when the index moves 10% in one direction or the other, you're not necessarily going to achieve double the opposite return on your holding.

A new study shows that because of their need to increase the bet on the daily index performance, ultra-short exchange-traded funds actually increase their "tracking error" and end up underperforming on a longer-term basis. The underlying FTSE/Xinhua China 25 index lost almost 48% last year, suggesting that the corresponding ultra-short ETF should have an implied return approaching 95%. However, because of the problem the study pointed out, it lost more than 53% in value. No doubt that's just one of the reasons Direxion Funds, one of the leading names in leveraged ETFs, says investors shouldn't hold these funds for more than a day.

There are some benefits to leveraged ETFs, such as being able to get around the prohibition on shorting in retirement accounts. But the risks are many, and these are perhaps not the best vehicle for most investors to use.

Highly rated CAPS All-Star member jstegma thinks the inverse ETF will still do well over the long haul, though, because of Chinese economic risks that hinge on a U.S. recovery: "China has big problems as demand from the US decreases. The market is currently drastically underestimating the effect of the US recession."

There's no need to fear ...
When underdogs have their backs against the wall, that's when they can shine their brightest, but it takes more than a few All-Star picks and a quick paragraph to make buy or sell decisions. So start your own research on these stocks on Motley Fool CAPS, where your opinion can still save the day. While you're there, you can read a company's financial reports, scrutinize key data and charts, and examine the comments your fellow investors have made -- all from a stock's CAPS page. There's more to CAPS than you think.