Are Inverse ETFs Always Bad?

02/22/2013 9:00 am EST

Focus: ETFs

Robin Carpenter of Cabot ETF Investing System discusses the best time to deploy these investments, which have been blamed for a sizable amount of 'user error' losses in recent months.

Sometimes, what you don’t know can kill you—even in the relatively controlled world of ETF investing.
For example, the Cabot ETF Investing System runs two strategies. The Long-Only strategy alternates between owning ETFs of favored S&P sectors (in uptrends) and holding cash (in downtrends). The Long-Short strategy—for more aggressive portfolios—holds those same favored sectors in uptrends, but sells short the S&P tracking ETF, S&P 500 SPDR (SPY), in downtrends.
But some investors—generally those with retirement accounts—are not allowed to sell short. So they ask whether they can use an inverse S&P proxy like the ProShares Short S&P 500 (SH) to capture gains in a downtrend.
That seems like an effective strategy on the surface, but I generally advise against it, and here’s why.
An inverse ETF like SH will do very well (gain value) when the market goes straight down. (And of course it will lose money just as readily if the market goes straight up.) But markets rarely go straight up or down. And it would even rarer to actually know in advance when the market will go straight down.

The best we can know is the probability that an uptrend or downtrend will continue. And even when our probability proves correct, most of the time the market will move in some kind of zigzag or on-and-off pattern—which works against the inverse ETF.
Because tracker ETFs seek to replicate their underlying indexes, the underlying stock portfolios are rebalanced daily. And the compounded returns of rebalancing cause a little erosion when the market fluctuates.
Consider a $10,000 investment in an inverse S&P ETF. Your investment controls $10,000 of the underlying index portfolio. That value will expand when the S&P goes down, and contract when the S&P goes up.
Suppose the index goes down by 1% one day and then bounces back to where it was the next day. That second day advance is slightly larger in percentage terms—approximately 1.01%. (100/99 difference from 1.00 is bigger than 99/100 difference from 1.00.)
So at the end of the first day, your original $10,000 is up 1% and is worth $10,100. Then on the second day, your ETF is down 1.01% of the $10,100, which is about $101. So the index is unchanged for the two-day span, and you’re down $1, holding only $9,999.
An actual short sale would have returned your original $10,000 on the second day, but the inverse ETF eroded a little. That kind of erosion is common in inverse ETFs, and even more so in leveraged ETFs.

The short-term up-and-down action (or down-and-up) nets a loss. The same erosion effect grinds on as long as there is fluctuation—which is almost always—and the bigger the fluctuation (volatility), the steeper the erosion.
But that doesn’t mean inverse ETFs are always bad. They are useful tools when there is reason to expect prompt decline in an index. Such a bet will be right or wrong (depending on your insight and analysis), but will not suffer from debilitating erosion, because you’ll have the answer very shortly.
Our ETF Investing System makes a different kind of directional bet. When our indicators turn negative, the Sell signal is not a time-specific prediction of decline. Rather, it says that market conditions are likely to bring a decline over the coming weeks (or sometimes months).

We don’t know how long the decline will take to get started, and we don’t know how long it will last, but we do know that our signals add value over time, and thus the system will pay off if we simply stick with it. And while there most surely will be up and down wiggles in the meantime, we won’t be penalized for them.
Subscribe to Cabot ETF Investing System here...

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