Inverse ETFs are exactly what they sound like: ETFs that try to perform the opposite to whichever stocks they’re tracking. Take for example an S&P 500 ETF. Such a fund will buy shares in the S&P 500 companies and when they go up or down in value the fund does the same.
Inverse ETFs aren’t quite that simple because, well, the opposite of buying stocks in the S&P 500 is to short them, and that comes with all sorts of potentially negative outcomes, like bankrupting the fund.
Using Derivatives to Inversely Track Targets
Thankfully, fund managers have another way to inversely track their targets: by using derivatives such as swaps and futures, funds can mimic the process of shorting the stock without actually doing so. Taking it a step further, by highly leveraging their funds, some managers aim to outperform their target by two or even three times.
In a perfect world, an inverse ETF would work like this:
1. Initial investment: $100.
2. S&P 500 ETF: Increases 10%.
3. S&P 500 Inverse ETF: Decreases 10%.
4. Final investment: $110 for both.
In reality though, it’s never that simple. First of all, inverse ETFs have tracking errors that average 20%. On 3x leveraged ETFs that error can reach up to 42%, according to CNBC. Then we have to discount the higher-than-average MER fees that inverse funds charge for their daily rebalancing. Finally, there’s the volatility problem. The longer an investor holds the fund and the more volatile the market, the more the returns diverge from their target due to compounding.
Here’s an example (albeit an extremely volatile one) of how an inverse ETF works in the long run (again assuming an initial investment of $100):
Day 1: S&P 500 ETF increases 2%. S&P 500 Inverse ETF decreases 2%.
Day 2: S&P 500 ETF decreases 10%. S&P 500 Inverse ETF increases 10%.
Day 3: S&P 500 ETF increases 10%. S&P 500 Inverse ETF decreases 10%.
Final investment: $100.98 from the S&P 500 ETF and $97.02 from the inverse ETF.
This “missing money” is quite simply explained. Inverse ETFs are not meant to be held for longer than a day and are reset each morning. The S&P 500 Inverse ETF aims to match the S&P 500 index by -1x for the day, not over an extended period of time. On day one, the fund decreased by 2% to $98, on day two it rose by 10% of the $98 dollars to $107.80, and on day three it lost 10% of the $107.98 to fall to $97.02.
In fact, the ProShares Short S&P 500 prospectus repeatedly mentions that the inverse ETF shouldn’t be held for more than a day to avoid the dangers of compounding. Looking at the returns, the year-over-year return is more than 1% different from the S&P 500, and the return since inception is more than 2% different.
The Bottom Line
While they need to be closely monitored and preferably managed daily, when used carefully inverse ETFs are a great middle ground for someone who’s bearish on the market but too nervous with the whole potential for unlimited loss that comes with shorting a stock.
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