Investors Should Be Very Careful With Inverse ETFs

From David Fabian: It’s easier than ever for investors to access complicated trading strategies using ETFs, but given the dangerous nature of some of these funds, it pays to understand them fully first.

The ubiquitous nature of ETFs ensures that they are accessible to virtually any type of investor in any type of account.  That’s generally a good thing for the majority of these low-cost, diversified, and tax-efficient tools.  Nevertheless, it also opens the door for complex and potentially unsuitable investments to make their way into places they should likely never appear.

Case in point is the growing use of short ETFs, which are also referred to as bear market or inverse funds.  These contrarian vehicles have become a “go to” tool for many active investors who wish to make a bet that the market will fall.

What Are Inverse ETFs?

These unconventional funds function by taking short positions and/or purchasing sophisticated derivatives such as swaps and options in an established index or group of stocks.  The goal is to achieve a negative correlation with a benchmark such as the S&P 500 Index.  This can be done in a direct 1x inverse correlation or with an embedded leverage component that magnifies price action by two or three times.

For instance, the ProShares Short S&P 500 ETF (NYSE:SH) is a popular way to achieve inverse daily price movement based on the S&P 500.  This ETF has nearly $2.7 billion in total assets and charges an expense ratio of 0.90%.  Its leveraged peer is the ProShares UltraShort S&P 500 ETF (NYSE:SDS), which magnifies this daily effect by a factor of two.

If you are ultra-aggressive, the Direxion Daily S&P 500 Bear 3x Shares (NYSE:SPXS) may have caught your eye.  This fund uses a leverage factor of three (or 300%) to achieve its stated goal of daily inverse returns of the benchmark, net of fees.  There are also inverse funds available that track individual countries, regions, sectors, fixed-income, and commodity indexes.  A full list of the 140+ offerings can be accessed here.

The key to owning any inverse ETF is to remember that performance statistics are achieved only on a daily basis.  The high expenses, use of leverage, decay of the underlying derivatives, and compounding effects work against the tracking of the benchmark over long periods of time.

Funds like SH and SDS have existed for over a decade now and have managed to function in a relatively satisfactory manner.  As with any ETF, minor hiccups in trading or tracking can occur at varying frequencies.  These are typically resolved in a timely manner and hasn’t meaningfully detracted from the use of these products.

How To Use These Funds

After understanding how these funds work, it’s important to ask yourself if inverse ETFs are suitable for your needs.  Most long-term investors are likely focused on growing and compounding their wealth through a combination of stocks and bonds.  They typically achieve a suitable risk profile through appropriate asset allocation decisions rather than market timing.  The high cost of these funds and the contrarian nature of the strategy may also detract from their appeal.

Investors who find success with inverse ETFs are those who are more actively engaged with their investment portfolio on a daily basis.  They likely have a more aggressive risk tolerance and want to achieve some level of protection for existing stock holdings or make a directional bet that the market will fall.

Under this latter example, timing is everything.  Inverse ETFs are not designed to be long-term holding vehicles.  Those who achieve the highest success rates are able to use them on a short-term basis and with a disciplined risk management plan such as a stop loss.

Alternative Strategies

It’s also worth noting there are alternative measures to inverse ETFs that can be reasonably implemented on a portfolio-level as well.  For example, using options strategies such as puts on single stocks or ETFs can achieve a similar hedging effect.

Furthermore, those who believe that the market will fall may opt to simply sell a portion of their holdings and move to cash.  That way, if you are wrong, the only thing that has been lost is opportunity rather than money.

The Bottom Line

Inverse ETFs can have suitable applications for those with an aggressive risk tolerance and familiarity with holding short positions.  Nevertheless, it goes without saying that these tools should only be used sparingly and may not be appropriate for all investors.

This article is brought to you courtesy of FMD Capital.

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