The Truth About Inverse ETFs

09/02/2009 12:01 am EST

Focus: ETFS

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

When the stock market is falling or a particular market sector or commodity is struggling, individual investors can make bearish trades that will profit from those declines. Traditionally, this meant that investors had to be able to short stocks or use options, but now there is another way to profit from the downside of the market using inverse ETFs.

Inverse ETFs, like leveraged ETFs, have been gaining in popularity very quickly. However, because they carry a unique risk that is often misunderstood, they are currently being vilified by some brokers and analysts. We feel that the real fault lies with uneducated investors who use these ETFs like gamblers or in other inappropriate ways.

Inverse ETFs are designed to produce the inverse returns on a daily basis of whatever index they are tracking. For example, if the S&P 500 were to fall 10% in a given day, an S&P 500 inverse ETF would be up 10% that same day. Some inverse ETFs are also leveraged and may be designed to deliver twice the inverse return of the index they are tracking.

This sounds like an ideal trading instrument for bearish investors who want to profit from a down market, and that is true to a certain extent. If the market is trending strongly and you have a short-term horizon, these are good ETFs for that purpose. However, inevitably the market channels over the long term, and that is when these ETFs can really get hurt.

The best way to explain the problem is with a simple math problem. Let's contrast what happens in a channeling but bearish market with two ETFs. The first ETF is based on a market index and goes up and down with stocks in general. The second ETF is the inverse of the first ETF.

In the video below, I'll provide even more detail by looking at leveraged ETFs as well.

Normal Indexed ETF

Day one starting balance = $100 and the market falls 20%
Day two starting balance = $80 and the market falls another 20%
Day three starting balance = $64 and the market rises 20%
Ending balance = $76.80 for a total loss of -23.20%

Based on this data alone, we would expect that the inverse ETF would be up exactly 23.2%. However, as you can see in the calculation below, this won't turn out to be true.

Inverse ETF

Day one starting balance = $100 but the market falls 20%
Day two starting balance = $120 but the market falls another 20%
Day three starting balance = $144 but the market rises 20%
Ending balance = $115.20 for a total gain of +15.20%

The inverse ETF did perform better than the normal ETF, but it underperformed expectations because the ETF is designed to match the inverse of the daily performance of the other index, not its long-term returns. This contra-compounding is the unique risk of inverse and leveraged ETFs.

This problem is particularly pronounced during channels when the market is moving up and down a lot. If the market is trending strongly, then the inverse ETF should perform close to expectations, but it will never be equal to the exact inverse over the long term. In fact, over the long term, an inverse or leveraged ETF is almost certain to be a loser no matter what direction the market goes.

Inverse and leveraged ETFs can be great for short-term trades, but their risks should not be ignored. Make sure that an inverse ETF can meet your trading objectives before you make the trade. Like any investment tool, if you ignore the costs and risks, you may be very disappointed in your long-term performance.

Watch the video for more details:

By John Jagerson of LearningMarkets.com.

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