An inverse exchange-traded fund is an exchange-traded fund (ETF), traded on a public stock market, which is designed to perform as the inverse of whatever index or benchmark it is designed to track. These funds work by using short selling, trading derivatives such as futures contracts, and other leveraged investment techniques.
By providing, over short investing horizons and excluding the impact of fees and other costs, performance opposite to their benchmark, inverse ETFs give a result similar to short selling the stocks in the index. An inverse S&P 500 ETF, for example, seeks a daily percentage movement opposite that of the S&P. If the S&P 500 rises by 1%, the inverse ETF is designed to fall by 1%; and if the S&P falls by 1%, the inverse ETF should rise by 1%. Because their value rises in a declining market environment, they are popular investments in bear markets.
Short sales have the potential to expose an investor to unlimited losses, whether or not the sale involves a stock or ETF. An inverse ETF, on the other hand, provides many of the same benefits as shorting, yet it exposes an investor only to the loss of the purchase price. Another advantage of inverse ETFs is that they may be held in IRA accounts, while short sales are not permitted in these accounts.
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Fees and other issues
Inverse and leveraged inverse ETFs tend to have higher expense ratios than standard index ETFs, since the funds are by their nature actively managed; these costs can eat away at performance.
Short-terms vs. long-term
In a market with a long-term upward bias, profit-making opportunities are limited in long time spans. In addition, a flat or rising market means these funds might struggle to make money. Inverse ETFs are designed to be used for relatively short-term investing as part of a market timing strategy.
Volatility loss
An inverse ETF, like any leveraged ETF, needs to buy when the market rises and sell when it falls in order to maintain a fixed leverage ratio. This results in a volatility loss proportional to the market variance. Compared to a short position with identical initial exposure, the inverse ETF will therefore usually deliver inferior returns. The exception is if the market declines significantly on low volatility so that the capital gain outweighs the volatility loss. Such large declines benefit the inverse ETF because the relative exposure of the short position drops as the market fall.
Since the risk of the inverse ETF and a fixed short position will differ significantly as the index drifts away from its initial value, differences in realized payoff have no clear interpretation. It may therefore be better to evaluate the performance assuming the index returns to the initial level. In that case an inverse ETF will always incur a volatility loss relative to the short position.
As with synthetic options, leveraged ETFs need to be frequently rebalanced. In financial mathematics terms, they are not Delta One products: they have Gamma.
[box type=”note” style=”rounded” border=”full”]The volatility loss is also sometimes referred to as a compounding error.[/box]
Hypothetical Inverse ETF examples
If one invests $100 in an inverse ETF position in an asset worth $100, and the asset’s value changes to $80 and then to $60, then the value of the inverse ETF position will increase by 20% (because the asset decreased by 20% from 100 to 80) and then increase by 25% (because the asset decreased by 25% from 80 to 60). So the ETF’s value will be $100*1.20*1.25=$150. The gain of an equivalent short position will however be $100–$60=$40, and so we see that the capital gain of the ETF outweighs the volatility loss relative to the short position. However if the market swings back to $100 again, then the net profit of the short position is zero. However, since the value of the asset increased by 67% (from $60 to $100), the inverse ETF must lose 67%, meaning it will lose $100. Thus the investment in shorts went from $100 to $140 and back to $100. The investment in the inverse ETF, however, went from $100 to $150 to $50.
An investor in an inverse ETF may correctly predict the collapse of an asset and still suffer heavy losses. For example, if he invests $100 in an inverse ETF position in an asset worth $100, and the asset’s value crashes to $1 and the following day it climbs to $2, then the value of the inverse ETF position will drop to zero and the investor would completely lose his investment. If the asset is a class such as the S&P 500, which has never increased by more than 12% in one day, this would never have happened.
Historical ETF example
For instance, between the close of November 28, 2008 and December 5, 2008, the iShares Dow Jones US Financial (NYSE: IYF) moved from 44.98 to 45.35 (essentially flat, properly an increase of 0.8%), so a double short would have lost 1.6% over that time. However, it varied greatly during the week (dropping to a low of 37.92 on December 1, a daily drop of 15.7%, before recovering over the week), and thus the ProShares UltraShort Financials (NYSE: SKF), which is a double-short ETF of the IYF moved from 135.05 to 117.18, a loss of 13.2%.
List of funds
Some inverse ETFs are:
AdvisorShares
AdvisorShares Ranger Equity Bear – NYSE: HDGE
AdvisorShares Athena International Bear -NYSE: HDGI
Boost
Boost 3X short Gold – LSE: 3GOS
Boost 3X short Silver – LSE: 3SIS
Boost 3X short Nat Gas – LSE: 3NGS
Boost 3X short Copper – LSE: 3HCS
Boost 3X short WTI – LSE: 3OIS
Boost 3X short FTSE100 – LSE: 3UKS
Boost 3X short Russell 1000 – LSE: 3USS
Boost 3X short Nasdaq 100 – LSE: QQQS
Boost 3X short Dax – LSE: 3DES
Boost 3X short Eurostoxx50 – LSE: 3EUS
Direxion
Direxion Financial Bear 3X – NYSE: FAZ
Direxion Technology Bear 3x – NYSE: TYP
Direxion Russell 1000 Bear 3x – NYSE: BGZ
Direxion Russell 2000 Bear 3x – NYSE: TZA
Direxion Russell MidCap Bear 3x – NYSE: MWN
ProShares
ProShares Short Dow 30 – NYSE: DOG
ProShares Short S&P 500 – NYSE: SH
ProShares Short S&P MidCap 400 – NYSE: MYY
ProShares Short S&P SmallCap 600 – NYSE: SBB
ProShares Short Nasdaq 100 – NYSE: PSQ
ProShares Short Russell 2000 – NYSE: RWM
ProShares S&P 500 Bear 3x – NYSE: SPXU
Horizons BetaPro
HBP S&P/TSX 60 Bear Plus ETF – TSX: HXD
HBP S&P/TSX Capped Energy Bear Plus ETF – TSX: HED
HBP S&P/TSX Capped Financials Bear Plus ETF – TSX: HFD
HBP S&P/TSX Global Gold Bear Plus ETF – TSX: HGD
HBP S&P/TSX Global Mining ETF – TSX: HMD
HBP NYMEX Crude Oil Bear Plus ETF – TSX: HOD
HBP NYMEX Natural Gas Bear Plus ETF – TSX: HND
HBP COMEX Gold Bullion Bear Plus ETF – TSX: HBD
HBP S&P500 Bear Plus ETF – TSX: HSD
HBP NASDAQ-100 Bear Plus ETF – TSX: HQD
HBP U.S. Dollar Bear Plus ETF – TSX: HDD
HBP MSCI Emerging Markets Bear Plus ETF – TSX: HJD
HBP DJ-AIG Agricultural Grains Bear Plus ETF – TSX: HAD
HBP U.S. 30yr Bond Bear Plus ETF – TSX: HTD
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