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While inverse/leveraged ETFs stake claim to a relatively small portion of the ETF industry by assets, accounting for just $27B in a sea of $1.4T (~2%), they represent 179 of the 1,239 (~14%) ETFs available as of 01/31/2013 (Source). So why the clear discrepancy between the level of assets ETF investors are willing to place in these ETFs and the number of ETFs providers are willing to bring to market? It may be because inverse/leveraged ETFs fail to add value in the context of a long-term portfolio and are likely to fall victim to the very financial shocks they are designed to hedge.

The Law of Compounding

Inverse/leveraged ETFs intend to magnify the returns of a target index or provide returns inverse to those of the index, often with two or three times leverage. One of the most well-established shortcomings of these structures requires only a basic understanding of the law of compounding. As the chart below illustrates, losses experienced by these funds can be severe, despite relatively small fluctuations in the underlying index.

(click to enlarge)

In practice, the failings of inverse/leveraged ETFs are also well-documented. For a tangible example, we can look to the performance of a traditional, long real estate ETF (NYSEARCA:IYR) and an inverse counterpart (NYSEARCA:SRS) during the housing meltdown in 2008. The traditional, long fund declined 39.88% for calendar year 2008, while the inverse fund declined a staggering 50.14% over the same period. Therefore, an investor who correctly identified the bubble in real estate prices would have been better off owning the long real estate ETF in relative terms.

Counterparty Risk

While the compounding effect is the most well-known shortcoming of inverse/leveraged ETFs, it is hardly the only risk factor for potential investors to consider. The daily returns delivered by these ETFs are created via swaps and futures contracts between the ETF provider and major financial institutions, such as Goldman Sachs and Merrill Lynch. As with any swap or futures arrangement, the contract is only as good as its counterparty. For example, an investor seeking to hedge against a "doomsday" collapse of financial institutions may wish to buy an inverse ETF on the financial sector. In doing so, the investor may be unknowingly exposing his portfolio to the very institutions he wishes to avoid. During 2008, in the midst of the financial crisis, one inverse fund was forced to suspend trading as short positions on financial stocks were temporarily disallowed by regulators. Because short positions could not be implemented, the fund was unable to identify a counterparty to enter into a swap agreement. The chart below provides a snapshot of the daily holdings of an inverse ETF (NYSEARCA:SDS).

(click to enlarge)

Cost Inefficiency

As with any investment, costs are a crucial consideration. In addition to the stated expense ratios associated with inverse/leveraged ETFs, which tend to be significantly higher than those of traditional, long only ETFs (SPY: 0.10% vs SH: 0.89%), there are transaction costs generated by the daily reconstitution process. One of the key benefits of index funds and by extension traditional ETFs, is that low portfolio turnover mitigates trading costs generated at the fund level, increasing the net returns realized by the end investor. Inverse/leveraged ETFs must be actively managed to achieve their daily objectives, increasing transaction costs dramatically. One study of actively managed funds, estimates that trading costs can range from 0.46% for liquid asset classes such as large cap stocks to 1.46% for less liquid asset classes such as small cap stocks on an annual basis (Source). When taken with the fund's stated expense ratio, total fee drag can be in excess of 2% per year for investors in inverse/leveraged ETFs.

Utility in Portfolio Risk Management

Perhaps most important to a long-term investor, is the potential for inverse/leveraged ETFs to improve the risk/return profile of a portfolio. Accordingly, we constructed several hypothetical models, dating back to the inception of inverse/leveraged ETFs in 2006. We used the world's largest ETF by assets (NYSEARCA:SPY) for long exposure to the S&P 500 in conjunction with each a 1X (NYSEARCA:SH) and 2X (SDS) inverse leveraged S&P 500 ETF . Furthermore, we applied an annual rebalancing rule in the same fashion as many long-term investors might. Even during this period, which included one of the largest market declines in history, the inclusion of inverse funds did not improve the risk/return profile of the portfolio as measured by Sharpe Ratio or Alpha over time.

(click to enlarge)

While theoretically an attractive vehicle for speculating on short-term market fluctuations, the law of compounding, counterparty risk, transaction costs, and modern portfolio theory combine to make a strong case against the use of inverse/leveraged ETFs by long-term investors.

The ETF Authority is a team comprised of two independent financial professionals, Nathan Rutz and Kevin Prendergast. This article was jointly written by Nathan and Kevin. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. The opinions expressed in this article are those of the authors and do not constitute investment, tax, or legal advice. Please consider your specific risk tolerance and investment objectives carefully before investing.

Source: Inverse/Leveraged ETFs: Inappropriate For Long-Term Investors