Q3 Review: Inverse ETFs Weren't Only Winners

October 03, 2008

Despite being whipsawed by increasing market volatility, long-only ETF investors still were able to benefit from several bright spots in the quarter.


If you were holding inverse exchange-traded funds of almost any sort during the past quarter, odds are your portfolio got a big boost.

All of the top 15 finishers in the third quarter that ended Tuesday were ETFs (and exchange-traded notes) focused on taking short positions. Whether it was tech, commodities or even utilities, inverse funds' total returns defied those of broader-based, long-only funds.

At the top was the ProShares UltraShort Basic Materials (AMEX: SMN) ETF. It gained more than 84% in the third quarter. The runner-up was the ELEMENTS Australian Dollar ETN (NYSEArca: ADE), which was up 87%-plus and was the only non-inverse fund in the group. (See complete list below.)

But other than traders and sophisticated investors trying to hedge their long investments in torrid conditions, short-focused ETFs probably hold limited appeal to long-term-oriented individuals. The third quarter didn't completely shut those types of investors out, however.

Although long-only investors didn't find as giddy of returns with more staid fare, several areas of the market did produce positive results. Those included:

  • In large-cap growth, four ETFs investing primarily in health care managed to earn positive total returns in the quarter. In fact, the Biotech HOLDRs (AMEX: BBH) wound up gaining 8.21%. Software and Consumer Services also outperformed the broader markets.
  • Financials didn't just bounce back, they roared back. The Regional Bank HOLDRs (AMEX: RKH) notched a nifty 18.98% gain and the iShares Financial Services (NYSEArca: IYG) made 7.97% in the quarter. Perhaps more than any other sector, though, Financials were a boom-and-bust story. The last two weeks were crucial. In fact, in the last two days of September, even the most diversified large-cap value ETFs saw their three-month returns drop nearly 50% only to jump back up on the last day of the month.
  • Consumer staples were especially strong for large-cap blend ETFs. And rather wide gaps showed up in funds following the same indexes and within the same styles. Most notably, SPDRs Trust (AMEX: SPY) underperformed its S&P 500-tracking iShares rival.
  • In small-caps, it was a tale of contrasting styles. Financials rebounded even more strongly in these segments of the market, leading specialty ETFs such as SPDR KBW Regional Bank (AMEX: KRE) to a 33%-plus return in the quarter. Funds tracking small-cap-oriented indexes targeting on homebuilders also scored double-digit gains. But even broader-based small-cap value funds such as the WisdomTree SmallCap Dividend ETF (NYSEAarca: DES) wound up with a better-than 10% return.

The late push by Financials and value-related stocks boosted the fortunes of ETF providers such as WisdomTree and PowerShares with their FTSE RAFI-based funds. In especially volatile times, paying attention to dividends and other fundamental valuations helped to lift those portfolios to top finishes across market-cap sizes. Several equal-weighted funds also finished relatively strong.

For a breakdown of top performers in the quarter by Morningstar's nine distinct asset classes and styles, see the lists at the end of this article for Q3 total returns based on the Chicago-based investment researcher's database.

But first, a short recap of the most liquid and closely followed categories might be in order; that is, large-cap ETFs in the three different styles—value, blend and growth.

As investors prepare for a final three-month push to raise dour 2008 returns, third-quarter trends point to continued volatility across markets, at least in the near term.

But much hinges on a $700-billion-bailout package for some of the world's biggest banks and financial services firms. And even if that passes both chambers of Congress, economists aren't expecting the ongoing global credit crisis to end right away.

The performance of the most liquid blue-chip stocks in the U.S. under such choppy waters is likely to undergo increased scrutiny. Perhaps the most transparent way to monitor the large-cap universe as a group is through exchange-traded funds.

Given this unique investing environment, following is a Q3 review of that category:

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