We have previously covered passively managed index ETFs.
Then we looked at actively managed and leveraged ETFs.
Next in the progression is inverse ETFs.
Inverse ETFs track a specific benchmark index. But the objective is to move in the exact opposite direction of the index.
Through the use of derivatives and advanced trading strategies, inverse ETFs essentially create short positions on the benchmark index. These ETFs profit when the benchmark index decreases in value. If the Standard & Poor’s (S&P) 500 falls 5%, an non-leveraged inverse ETF, such as the ProShares Short S&P500 (SH), should rise approximately 5%.
Unsurprisingly, inverse ETFs are also known as “short” or “bear” ETFs.
According to Morningstar, as at December 31, 2009, there were 90 inverse ETFs with assets of USD 19 billion. So not a large investment category. But given the uncertain markets over the last few years, there is investor demand for these products at the moment.
In 2009 alone, there were 17 new inverse ETFs launched. They seem to be especially popular in specific market sectors and commodities.
The definition of inverse ETFs has some flexibility. It often includes funds that employ leverage to enhance short positions and accelerate relative returns. For example, Direxion Daily Financial Bear 3X Shares (FAZ) utilizes significant leverage to short shares in the financial sector.
Advantages of Inverse ETFs
Markets Do Not Continuously Rise
If you believe that a specific market will decline over a certain time period, inverse ETFs give you the opportunity to profit from a short position.
Some investors wish to pursue bear market trading strategies in anticipation of a negative market. Other investors want to use inverse ETFs to hedge their long positions in the market.
I am not an advocate of paying for professional management. However, I also do not recommend trading derivatives and shorting securities for many non-professional investors.
If you plan to engage in these activities, it may make sense to pay a professional to do it for you.
No Margin Required
If you short individual securities or indices, you require a margin account. But investing in inverse ETFs does not necessitate opening a margin account and worrying about margin calls.
Additionally, shorting securities within a margin account can be extremely risky.
In theory, shorting a single stock can result in an infinite loss to the investor. This would occur if the share price continued to rise and the investor was not able to close his position. Not a practical concern for most investors, but there is the possibility for significant losses should the share price rise sharply in a short period.
With inverse ETFs, there is no possibility of an infinite loss. At most, you will lose the money used to buy the ETF. Your loss will cap at 100%. Not good, but better than 1000% or more.
Good Variety of Inverse ETFs
Finally, there are a variety of inverse ETFs available. Should you so desire, you can short broad market indices or individual sectors.
Some investors utilize inverse ETFs to target specific sectors or commodities for speculative, hedging, or commercial purposes.
Disadvantages of Inverse ETFs
Increased Complexity, Increase Cost
As with other more complicated ETFs, the greater the work involved, the greater the expenses.
When we looked at long ETFs that track the S&P 500, we saw that both the S&P Depositary Receipts (SPDR) S&P 500 ETF (SPY) and iShares S&P 500 Index (IVV) had total expense ratios (TER) of 0.09%.
What about an ETF that tracks the same index but takes a short position?
As at May 31, 2010, the inverse ETF ProShares Short S&P500 (SH) had a TER of 0.92%.
Once again, a significant price is paid for the more complex fund.
In using derivatives to short the index, there may not be a perfectly negative correlation.
Or, over time, the ETF may experience return drift as small tracking imperfections magnify. The greater the time frame, the greater the potential deviation.
Both of these can impact the performance of the ETF and not allow it to inversely mirror the index’s returns.
I have never invested in inverse ETFs.
But that is mainly because I do not like to pay management fees and am I able to use derivatives and margins to short positions when I wish.
For investors that cannot, or do not want to trade derivatives or personally short securities, it may be worth it to pay a management fee for this service.
When to Potentially Use Inverse ETFs
I would not advise investing in inverse ETFs as a long-term strategy. That would assume the markets will continuously decline in value. Likely not a valid assumption. But if it was, the markets can only fall so far and there would hopefully be other asset classes that would make better long-term investments.
Instead, using inverse ETFs as short-term hedges may be prudent. Locking in investment gains or seeking protection from anticipated declines in specific sectors.
Others may utilize inverse ETFs to engage in market or sector timing activities. Not necessarily a bad strategy but be aware that trying to time market movements is extremely difficult.
At times, I pursue market timing tactics so I will not dismiss this outright. Just remember that market timing can be risky and may not be appropriate for long-term investing.
Analytical Keys When Selecting an Inverse ETF
In selecting an inverse ETF, analysis should focus on three areas.
One, what is the experience and track record of the fund managers? If you plan to pay for professional management, you want to hire the best you can find.
Two, how well does the fund inversely replicate the performance of its benchmark index? If you believe that an index or sector will decline, you want to make sure that the inverse ETF will rise in approximately the same proportion.
Three, what is the fund’s TER on both an absolute basis as well as relative to the ETF’s peer group and alternative investments? There may be significant differences between TERs on inverse ETFs tracking the same index. Always try to get the best performance for your investment dollar.