Credit: Shutterstock photoExchange-traded funds that move inverse to the stock market have become increasingly popular during the latest round of downside volatility. A growing base of investors have come to rely on these sophisticated tools as a means to profit when stocks are falling rather than the traditional methods of options or shorting individual stocks. Yet few understand how these vehicles are able to maintain their inverse relationship to established indexes or what risks are involved in the process.
How Inverse ETFs Work
An example of this type of fund is the ProShares Short S&P 500 ETF (SH), which tracks the inverse daily performance of the S&P 500 Index. Simply put, when the S&P 500 Index declines by 1%, SH will rise by 1%. This makes the investment vehicle relatively easy to understand, but underneath the surface there is a great deal more going on.
To accomplish its mandate, ProShares uses a combination of futures and derivatives (or swaps) that allow the fund to continually track the benchmark throughout the trading day. The creation and redemption process, which is a direct result of investor trading, allows SH to stay in lock step with its index counterpart. The fund is then rebalanced every day in order to maintain that consistent tracking.
The daily rebalancing creates a dependable pattern for investors to rely on short-term moves in the stock market. However, this system also creates small divergences over time as a result of compounding and expenses that add up to big differences in total return. The chart below is a performance comparison between SH and the SPDR S&P 500 ETF (SPY) on a year-to-date basis.
One would naturally assume that the performance of each fund should be mirror opposites, yet the concerns mentioned above have worked to create a 2% gap in total return.
Investors considering inverse ETFs should be aware that these complex strategies come with higher embedded expenses as well. SH charges a net expense ratio of 0.90%, which is understandable considering the constant maintenance that the fund requires.
Using Inverse ETFs
The underlying structure of inverse ETFs has proven to be a fundamentally sound method of tracking the opposite price moves of an index on a daily basis. As such, it should come as no surprise that these types of funds are most appropriate over short-term time horizons. Even minimal levels of decay in tracking over time can produce adverse effects on your capital or loss of faith in the efficacy of these tools.
It also goes without saying that inverse ETFs should only be considered for those that are comfortable betting against the market. That usually coincides with an aggressive tolerance for risk and implicit understanding that the natural tendency of indexes is to move higher over longer time frames.
If all of those criteria are met, a fund such as SH may be most appropriate as a tactical opportunity to profit during a down cycle in the market. This ETF experienced net inflows of over $500 million during the two-month period of excessive volatility in August and September of this year. SH gained over 8% during that time frame, which underscores the high demand for inverse ETFs during periods of stress in stocks.
While inverse ETFs can be used as stand-alone trading vehicles, they may also be attractive as hedging strategies. Adding an inverse ETF to your portfolio can allow you to reduce the overall impact of a drawdown on other highly appreciated stocks that you may not want to sell. In other words, a hedge can act as a way to minimize peaks and valleys in an otherwise fully invested account.
Lastly, inverse ETFs can be used in IRA’s and other retirement accounts where it may be obstructive to add margin for traditional options or short capability. This style of fund is ultimately traded just like any other conventional ETF.
The Bottom Line
Deciding whether an inverse ETF is right for you should be a personal exercise in understanding the products and your investment goals. This will support your trading thesis and avoid any missteps or surprises that come from a lack of due diligence. Additional care should be taken to define your risk parameters and implement a sell discipline where appropriate as well.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
