The Pitfalls of Using Inverse ETFs

Each year we see new financial products come to market. While many wish we had never seen collateralized debt obligations (CDO), structured investment vehicles (SIV) or auction rate securities (ARS), some new products serve an important investment niche. An example of a new product with powerful trading and portfolio management uses is the inverse ETF.

Inverse ETFs are designed to offer the opposite return on defined index. If the underlying index declines 1%, the inverse ETF will rise 1%. In a bear market, these ETFs offer an attractive alternative to shorting stocks. Further, tax advantages exist for owning an inverse ETF versus being short of a stock.

Over the months, I have often recommended inverse ETFs in EPIC Insights, my weekly newsletter. Particularly, I like to use double inverse ETFs (doubles). These instruments will return twice the return of the underlying index which means a 1% drop in the index offers a 2% positive return.

The strategy of using inverse funds to express a view seems simple, but there is one key caveat to remember. The inverse ETFs are designed to return the inverse performance of the underlying index on a daily basis. At first look, this appears to be insignificant. After all, any long term period is comprised of a series of shorter periods so why wouldn't the series of daily moves equal the long term movement?

To illustrate the danger of relying on a series of daily moves to express a long term view, I ran three scenarios. All three time series will lose 10% over a 20 day period, but the return patterns differ. Scenario 1 shows a straight trend where all 20 days are equally negative. Series 2 shows minimal volatility where every price movement is within a range of -2% to +2%. Series 3 shows large volatility where all positive moves are greater than 5% and all negative moves are worse than -5%. The surprising results were as follows:

Index

Move

ETF

Inverse

Straight Trend

-10%

-10%

23%

Minimal Volatility

-10%

-10%

22%

Large Volatility

-10%

-10%

-20%

Knowing the underlying index has declined 10%, I would expect the double to return nearly 20%. This occurred in the straight trend and minimal volatility scenarios. However, large volatility not only failed to deliver the 20% desired return, it resulted in a large loss that exceeds the loss of the underlying index. How can a double lose more than the index off which it is based? By delivering daily moves in a highly volatile environment, massive price swings reversed the double's intent and created an unexpected loss.

Armed with this information, should we dismiss inverse ETFs as another member of the alphabet soup disaster and toss them aside with CDOs and SIVs? As mentioned earlier, I continue to use doubles and believe they have an important role for individual's portfolios. However, you cannot predict a market move, buy the doubles and expect gains. Instead, investors must also consider how volatile price movements will be. In a scenario where volatility is low, inverse ETFs are powerful tools for long term investors. When volatility is high, the ETFs should be used as trading vehicles that allow you to express a short term view. By considering the direction and path of price movements, investors can optimize their performance and prevent the unpleasant surprise that accompanies an investment failing to fulfill your expectations. Next time you decide to purchase SKF or QID to express views ask yourself if this is a trade or an investment. The designation may seem subtle, but the difference in return will be immense.

Comments

[Briggsy:]

They even have triples now!

2008 Dec 31 04:44 PM

[Fitz919:]

I'm using the Triples, but I will like them even better when the daily share volume increases substantially. The spreads between bid and ask are often 5 cents, 10 cents or more. I'll be happier when the spreads are a consistent 1 cent, or 2 cents, with enough shares available at those prices so I can use Market Orders to capture gains more consistently, and reduce the size of the occassional loss. I'm making my Mark to Market Election, and the Triples will be a big part of my 2009 strategy. Boy do I love the volatility.

2008 Dec 31 07:56 PM

[cma cma:]

"In a scenario where volatility is low, inverse ETFs are powerful tools for long term investors. When volatility is high, the ETFs should be used as trading vehicles that allow you to express a short term view."
Since investors have no way of knowing what volatility will be, all the ETFs that use swaps, etc. are like buying options: the buyers suffer from time decay, often a great deal of it. They are a loser's game.

2008 Dec 31 10:27 PM

[BrucePile:]

Why do they call them funds? If they only track the underlying index for 1 day and are worthless for anything but a day trader, why on earth are they presented as an investment or fund hedging tool? What an idiotic outrage.

2008 Dec 31 10:29 PM

[Phil Trupp:]

The inverse ETF has acted as another WMD in the ongoing wreckage of this market. It has encouraged the mania of irrational shorting by placing a negative premium on stock destruction. Yet we enter a brand new year reeling from the criminal manipulations of the '08 market, and still we encourage the use of yet another gimmick designed to further weaken the financial architecture and add a greater uncertainty to the future. The markets have been abused from the top down, starting with G.W. Bush's primitive deregulation mantra to SEC Chairman Chris Cox's criminally unethical neglect of enforcement. And there is plenty of blame to go around in Congress, where corporate contributions to presumed legislative watchdogs have encourage words and little or no guidance through the financial storms. Hedge funds remain unregulated, and the entire federal establishment has neglected to stop to the collusive rumor- mongering and short selling that makes long term investment virtually impossible. The SEC never should never have endorsed reverse ETFs or suspended the 70-year-old safety net of the up-tick rule which made buy and hold a sensible, investor-friendly strategy. Those who continue to use reverse ETFs will, in the long run, shoot themselves in the foot and further cripple an already tortured market.

Jan 01 01:30 PM

[Urbane Gori...:]

Sean... I like your weekly letter quite a lot. Well thought out and particularly useful.

Just pointing out here that problems with these inverse and ultra ETFs has been noted quite a lot lately. 'Trader Mark' performed a nice analysis of the gains and losses as well. (You can Google his site and pull up his prior articles.)...

And, I have noticed several times in the last year where both the primary and inverse ETFs have actually traveled the same direction. Quite odd.... But it does serve to underscore that they are not perfect in their application. Lately, I suspect that the unusual moves may be more to do with abandonment of the Proshares for the above-mentioned triples by those that like to dance on a high-wire.

jegan

Jan 01 02:04 PM

[bsharvy:]

The problem with the UltraShorts is not explained by volatility alone, nor is it explained by daily rebalancing. Many of the UltraShorts underperform a short position in the corresponding UltraLong. Since UltraLongs and UltraShorts have the same volatility, volatility isn't an explanation. Ditto for daily rebalancing. The explanation doesn't involve any fancy math, but merely common sense: The UltraShorts don't work as advertised.

Jan 01 07:20 PM

[fjpenney:]

As has been noted in some of the other discussions on ultra ETF's, in a falling market it is better to short the bull ultra ETF than it is to buy the inverse ultra ETF. Of course, this assumes that you can short the ultras which may or may not be difficult. After participating in a similar discussion about this issue, I checked with my broker last week and they did have a small amount of QLD available for me if I wanted to short it. Now is not the time to short QLD.

The inverse of my above statement isn't true: it is better to buy the long ultra ETF in a rising market than it is to short the inverse ultra ETF.

Fred

Jan 02 05:48 AM

[CLH:]

I use the ultras when stocks are going up. Stocks tend to go up slowly while going down rapidly making the ultra shorts something to stay away from.

Jan 02 09:36 AM

[Kunst:]

These ultra & ultrashort ETFs are extremely dangerous if you hold them for any length of time. Run some charts and you will see.

Examples, 1/1-12/29/08:
China: FXI and FXP are both down 50%.
Oil industry: DUG is down 25% and DIG is down 75%.
Financials: UYG is down 85%, SKF is up 25%.
Real estate: URE is down 80%, SRS is down 45%.

DOG (ProShares 1x short Dow 30) is up 20%, DXD (same except 2x) is only up 15%. The single-leverage did better than the double!

If you hold on to these ETFs for more than a few days, you are on a losing track. Beware!

Jan 03 01:29 AM

[slipper:]

thanks for your article on the pitfalls of inverse ETF's. using mozilla however, the table of results is very difficult to interpret.

Jan 03 05:41 PM

[PharmBoy:]

I wish I had read this article *before* buying FAZ. On the plus side, stochastics are heavily oversold, RSI just crossed over from oversold conditions, it looks like a triple bottom has formed, and banks have more bad news to report. So what's the dilly yo? Any chance of this stock seeing the 80's and 90's again? I'm tempted to hedge with buying some BAC or JPM calls (probably 2011 LEAPs).

Jan 05 07:11 PM