Tackle Inflation with These Funds

In the ongoing process of slicing and dicing the investment universe into ever-narrower parts -- such as funds that invest in one currency, funds that buy a single precious metal and funds that invest solely in home construction companies -- the industry churns out a vast number of inane products. But occasionally one such narrow slice might match exactly what you're looking for.

Investors concerned with rising interest rates may find such a match with the ProFunds mutual funds and ProShares exchange-traded funds (ETFs) designed to inversely track treasury prices. Bond prices move inversely to interest rates, so the funds, by definition, will profit when rates rise and sink when rates fall. And since interest rates tend to rise in response to inflation, as bond investors demand greater compensation for tying up their money, you could also see the funds as an inflation play.

There are four offerings from which to choose. ProFunds Rising Rates Opportunity 10 (symbol RTPIX) tracks the inverse of the daily price return of the 10-year Treasury. ProFunds Rising Rates Opportunity (RRPIX) uses leverage, or borrowed funds, to capture 125% of the inverse of the daily price return of the 30-year U.S. Treasury. The newly launched ProShares UltraShort Lehman 7-10 Year Treasury (PST) ETF employs leverage to capture twice the inverse of the daily performance of the seven to ten year Treasury, as tracked by the Lehman Brother's index. And the ProShares UltraShort Lehman 20+ Year Treasury (TBT) does the same for Treasuries of 20 years or greater maturity.

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It's a simpler concept than it sounds. If the price of the 30-year Treasury goes down 2% one day, then Rising Rates Opportunity will go up by 2.5% that same day. The funds use derivatives to reach these intraday goals, but there's no guarantee of precisely how that tactic works out over longer periods. "When a fund has a daily objective, there can be compounding that occurs over a longer period of time that affects returns," says ProFund Advisors chief executive Michael Sapir. That compounding could add to or subtract from returns over a given period, he says.

They're blunt tools, but the funds offer as precise a play as you'll find on rising rates. And they're more user-friendly than short-selling -- or borrowing and selling on the market, in the hope of repurchasing later at a lower price -- shares of a Treasury ETF. Just opening an account that permits short-selling is complicated, plus potential losses are unlimited when you short sell. Shares can only lose 100%, but they can gain an limitless amount.

Performance shows the funds deliver the goods they purport to. When the interest rate on the ten year Treasury fell from 5.3% in mid-June 2007 to 3.3% in mid-March 2008, Rising Rates Opportunity 10 lost 13.4% and Rising Rates Opportunity lost 17.7%. Since then the ten year rate has bounced to 3.9% and the funds have gained 3.7% and 5.4%, respectively. Since its inception on May 1 the 7-10 Year ProShares has gained 2.5% as its benchmark lost 1.2%. Meanwhile the 20+ Year ProShares gained 4.9% as its benchmark lost 2.4%.

These are timely offerings. Plenty of experts, such as Pimco's Bill Gross, say the flight-to-quality in bonds that drove Treasury yields down to near historic lows early this year far overshot the mark. And in June commentary on the Pimco Web site, Gross made a strong case for investors' needing to aggressively tackle inflation. Other investors seem to agree -- $125 million has already flowed into the new ETFs.

But even Bill Gross would need to use these creatures cautiously. No one's blown a whistle to say that the credit crunch is over, and a flare up could send Treasury rates for another tumble. To employ leverage on the upside means you also have to accept it on the downside, which magnifies any losses. And no one will watch rates for you to decide when to pull out your money.

Sapir says the funds could make sense as a permanent interest rate hedge for bond investors' portfolios, but the funds' expenses say otherwise. Both Opportunity and Opportunity 10 levy a 1.46% expense ratio, while both ETFs charge 0.95%. Morningstar analyst Marta Norton says investors looking for a hedge against rising interest rates would do better to buy a low cost short-term bond fund. She recommends Vanguard Short-Term Federal (VSGBX), which charges a comparative pittance of 0.20%.

But for aggressive investors looking to make a very specific bet, these funds will do just fine.