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:
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.