The Hidden Cost in Inverse ETFs

by: Convergence Investments

During these past few months of turbulence and bearish trends in the market, I’ve heard increasing interest in the new classes of short – and double short – ETFs. An attractive premise: make money on the downward moves, even if you’re not able to short or aren’t able to locate shares, and with relatively low management fees, they’re a much more attractive option than traditional short selling or put options.

However, there’s a very significant yet very subtle cost to holding these ETFs. This cost, while explained in the prospectus and in a handful of posts and comments on Seeking Alpha, is not well understood by many.

Short/double-short ETFs state that they “seek to match the daily investment results, which correspond to the inverse of the daily performance of the [underlying]”. True to form, they typically come quite close on a daily basis. But there’s a catch. If the market moves up 10% one day (say, S&P 1000 to S&P 1100) and then drops right back to 1000 the next day, the short ETF (SH, for instance) would have lost 10% on the up move, but only gained 9% on the down move (100 points is ~9% of 1100). Over a period of a few days in a relatively normal market, this amounts to mere rounding error. However, as the holding period becomes longer, and the market becomes more volatile, this gets magnified.

As an illustration, let’s say you were holding $10,000 of an S&P500 basket of stocks and wanted for whatever reason to hedge it with an inverse ETF. You could choose SDS, which mirrors double the inverse performance of the S&P and purchase $5000. Every day, it seems as if your percentage moves are pretty well hedged, so all is well. Except it’s not. See the below table to see how 2008 would have treated this perfectly hedged strategy.

While management fees for the year amount to about 1%, the hidden tax you’re paying is over 13%! Since it’s really day to day volatility that cranks up this penalty, I’ve included approximate VIX averages for each month. Clearly, as long as the volatility stays up, the cost of these instruments is much greater. Unfortunately, high volatility is exactly what leads these to be such attractive additions to your portfolio.

Of course, every losing trade should have an equal and opposite winning trade. I’m considering taking the opposite of this trade – short the SDS and long the IVV. While this is not a risk free arbitrage (unexpectedly low daily volatility could lead to the opposite effect), in the current market this doesn’t seem likely.

Disclosures: None.