Inverse ETFs are funds that try to perform the opposite of an underlying index or sector. Investors with a buy-and-hold strategy can use these ETFs to hedge their position if they’re fearful of short-term market performance. Conversely, if an investor is wrong when trying to time the market, he or she could see the market rise while the inverse ETF falls.
The biggest pro of inverse ETFs is that holding one is an opportunity to make money while the stock market is crashing. In the dark days of the Great Recession, the ProShares Short S&P 500 inverse ETF (SH ) was up 38.81% overall in 2008.
For an investor thinking in the short term, inverse ETFs are a great way to protect your portfolio. If you hold long bull positions in the market, buying an inverse ETF the morning of a big announcement from the U.S. Federal Reserve means that whatever the announcement may be, you’ll more or less break even. With inverse ETFs that use leverage to return 2x or 3x the inverse of its target, an investor expecting bad news can set himself or herself up for a quick portfolio boost.
A more seasoned investor may prefer to short a stock or ETF, but that comes with the potential for unlimited losses and needs to be done in a margin account. As certain registered or retirement accounts don’t allow investors to trade on margin, inverse ETFs are an easy way to hedge a portfolio or gain from a market downturn.
While compounding is the best friend of the saver, it’s the enemy of the borrower. For investors holding inverse ETFs, it is crucial to realize that compounding works against the investment holder, especially in a volatile market. An inverse ETF that meets its target every day never matches its non-inverse ETF gains over a longer period of time. For example, the S&P 500 has returned an average of almost 18% per year in the latest five-year period, while SH has been down almost 19% per year in the last five years.
The compounding problem is exacerbated by funds that borrow heavily to leverage the ETF into a 2x or 3x inverse ETF. In fact, according to CNBC the tracking errors on inverse ETFs can range from 20% to 42% on a yearly basis, with the higher range for 3x leveraged ETFs. It’s for this reason that inverse ETFs should only be held in the short term – a major con for long-term investors.
As inverse ETFs are adjusted daily and monitored more frequently than non-inverse ETFs, their management expense ratio (MER) fees are higher than their normal-indexed counterparts. For example, the SPDR S&P 500 ETF (SPY ) has a gross MER of 0.11% while SH has an MER that’s over eight times higher at 0.89%.
The Bottom Line
Ultimately, inverse ETFs are a great short-term tool to avoid portfolio losses when the market is in a downturn. But the math behind inverse ETFs shows that it’s not ideal to hold them for an extended period unless you have an extremely bearish view of the market.
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