Profiting from the Subprime Mess

Real estate prices are falling, foreclosures are up and financial institutions that rolled questionable subprime mortgages into investment vehicles have announced billions of dollars in write-offs. The Dow Jones Industrial Average has dropped more than eight percent since Oct. 9 (when it peaked at 14,164), dragged down by shares of home builders, real estate firms and banks.

The economic forecast doesn't look good. Credit is tightening, the economy is slowing and some analysts predict subprime problems will persist until home prices stop sliding. A bleak scenario for investors? Hardly. There's plenty of money to be made out there, if you know how.

One way investors have profited is by shorting stocks - betting they will fall further. We've all heard of professionals on Wall Street doing this, but how do regular, small-time savers like you and me do that? Through ETFs.

Exchange-traded funds, or ETFs, are funds that can be bought and sold like stocks. They aren't exactly like stocks, however, because they tend to focus on groups of stocks or the market as a whole, rather than on individual companies. They're also usually more expensive to trade because you need to pay fees on top of trading commissions when you buy and sell them. But they've opened up a whole new world of money-making possibilities to investors, including the shorting of sector stocks.

Shorting Real Estate (SRS)

One ETF that has done extremely well recently is UltraShort Real Estate ProShares (SRS), an investment vehicle that increases in value as real estate stocks fall. (SRS corresponds to twice the inverse of the daily performance of the Dow Jones U.S. Real Estate Index, which means it rises twice as fast as that index falls.) It has climbed more than 50 percent in value since its inception at the end of January 2007 (as of Nov. 16, 2007).

A rise of 50 percent is amazing, but the ETF's actual return is lower, due to a hefty management fee of 0.75 percent and a gross expense ratio of 1.24 percent. (That'll cost you $12.40 for every $1000 invested.) Still, its performance is impressive.

If you believe the worst is over and real estate stocks have hit bottom (you want to "buy low"), you might find the even more expensive Ultra Real Estate Proshares ETF (URE) more to your liking (gross expense ratio: 1.87 percent). It's designed to rise twice as fast as the Dow Jones U.S. Real Estate Index, and has fallen 44 percent since its inception.

Shorting the Financial Sector (SKF)

In the same way falling real estate stocks have boosted shares of SRS, falling financial institution shares have boosted UltraShort Financials (SKF), yet another ProShares ETF. This one rises at twice the rate the Dow Jones U.S. Financials index falls, and so far SKF has climbed 41 percent since Jan. 30, 2007. Like its brothers, SKF is not cheap, charging 0.75 percent in management fees and featuring a gross expense ratio of 1.30 percent.

Again, however, if you feel the stocks of financial institutions have hit bottom and are soon going to tend upward, you may want to look at Ultra Financials ProShares (UYG), which rises at twice the rate of the Dow Jones U.S. Financials index (management fee: 0.95 percent; gross expense ratio: 2.28 percent). UYG has fallen 37 percent since Jan. 30, 2007.

(You may think this is an ad for the ProShares family of funds, but it isn't. In my research, I simply haven't found any other regular or shorting ETFs that have risen so high (SRS, SKF) or fallen so low (URE, UYG) this year, as the those I mentioned. They aren't cheap, but buying the ETFs above will turbo-charge your portfolio. Just make sure you bet the right way.)

NOTE: You invest at your own risk. The author and this website cannot be held responsible for investment losses incurred by readers of this article. (Be careful. You could lose your shirt.)