As active investors continue to watch their portfolios fall, it is natural for even traditional buy-and-hold investors to not only consider liquidating existing positions, but also think about ways to hedge their portfolio (or even profit from the relentless downward trend). Since the easy short money has probably already been made, some investors and traders are turning to 2X and 3X inverse or short ETFs to juice returns. While such ETFs have been in existence for a while, and articles detailing the uses and pitfalls have surfaced (see two recent 2009 WSJ articles here and here), it is still worth reminding investors how double, triple, and inverse ETFs are better suited for day traders, and are not perfect tracking vehicles past one day. The reason for this is that with the right type of daily moves over an extended period of time, compounding errors can result in inverse ETFs generating overall losses, even when the reference index is down considerably. Tom Lauricella's WSJ article outlines why:

"For example, take a double-leveraged fund with a net asset value of $100. It tracks an index that starts at 100 and that goes up 5% one day and then falls 10% the next day. Over that two-day period, the index falls 5.5% (climbing to 105, and then falling to 94.5). While an investor might expect the fund to fall by twice as much, or 11%, over that two-day period, it actually falls further -- 12%. Here's why: On the first day, doubling the index's 5% gain pushes the fund's NAV to $110. Then, the next day, when the index falls 10%, the fund NAV drops 20%, to $88."

So while a 2X short ETF will double your daily returns when the associated index is down by X, holding periods longer than one day are subject to compounding variations. Unfortunately, such compounding effects may not be the only surprise for long-term investors of index ETFs, or even those with shorter holding periods. Investors need to fully understand what is being tracked. For instance, the popular USO ETF actually trades based on crude oil futures, and not the spot price of crude. As such, if futures prices do not increase as much as the spot price, your ETF may end up gaining less than expected. Rolling from one contract month to the next could also cause gains or losses. If the crude oil futures market is in contango (futures trading for more than spot), rolling over the futures from one month to the next could generate a large loss for the ETF, and lower gains for the investor, as new positions are purchased at a higher price [Note: for a good overview on the issues regarding the USO, see the following seekingalpha article].

As with all ETFs, make sure you look beyond the name, and have some idea how the price is set. The various 2X and 3X inverse ETFs may not be giving you the type of long-term hedge or position you are expecting, and the commodity ETFs may not be following the spot price as anticipated. Finally, always be sure that any index the ETF is following actually has the type of diversification and representation you are looking for. Some industry ETFs may be heavily weighted in just a few companies, or may be focused more on a specific sub-industry.

There has been a lot of discussion lately regarding the surge in volatile late-day trading that has occurred since the summer sell-off and fall credit-crisis began to unfold. In November alone, an average of 26.2 percent of trading volume in S&P 500 stocks took place in the final hour of trading, with 17.1 percent of the trading occurring in the final 30 minutes (see WSJ article). Furthermore, for eight of the ten worst days for the S&P 500 since September 1st of this year, 29 percent or more of the move took place in the final hour of trading, with three instances in which over half of the market decline occurred during the last hour. Much of the blame for the late day sell-offs has been assigned to hedge fund redemption selling, or simply nervous traders unwilling to hold positions overnight. A possible new culprit may be ETFs, in particular, leveraged ETFs.

Leveraged ETFs, now numbering over 100 in total (see lists here and here), have recently become popular since they allow market participants to take 2X and 3X positions on popular stock and sector indexes. Many of the leverage ETFs utilize swaps and options to achieve their leverage ratios. Not surprising, when the linked index or sector falls, corresponding stocks in the ETF have to be sold at a two to three times greater rate, increasing the moves in the indexes. In fact, the trend has become so predictable that many proprietary trading desks actively trade the levered ETFs toward the end of trading days with large moves, knowing that increased buying or selling is on its way. While the VIX has been coming down over the last few weeks, it is still at elevated levels, indicating that the next big daily move up or down is likely to be capped off with an equally impressive last hour move, generated in part by momentum investors taking a position in leveraged ETFs. For once, the market (myself included) has someone else to blame besides the hedge funds for late day trading volatility.