Weak Market: Buy Inverse ETFs? Here's Why Not, Except For A Few

 |  Includes: DUST, EDZ, SCO
by: Peter F. Way, CFA

Inverse-structure (or short) ETFs are generally recognized as having an inherent downside price bias, making them only suitable for short-term trades. But in a market that may be turning down, are they worth a quick gamble?

The guys most likely to know are the market-making [MM] pros that every day have to factor the short-term market outlook into the at-risk positions they commit their firms to. Besides hedging those positions, they are ever alert to capitalize on good opportunities with their own personal capital, the same way porcupines make love - very carefully.

This crowd is often active in these instruments, knowledgeably, one way or the other. What are their actions suggesting today about what may happen to the market in the next few days? Here is what their hedging/speculating actions tell us:

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(used with permission)

This map locates the various Inverse ETFs according to where their end of day price was located in the range of prices implied to be likely, from their bets currently being made. The distance to the top of those ranges from the EOD price represents the upside, and to the bottom is the downside. ETFs on the diagonal line are seen to have equal balance up vs. down.

Most currently occupy space below the diagonal where upsides predominate. But the further away from that lower left corner, the more uncertainty is present, including that downside risk on the left-hand vertical scale.

So are EWV at [37] and KOLD at [25] and BIS at [38] where you want your long-bet money on a down market to be? Maybe not. Better to find out how good a guide this approach has been in the past, and where these guys have had their best insights among the large array of choices present.

We check out their past by looking to see what has actually happened to prices in days, weeks, and even months following past forecasts like those being made at present. Our guide is that balance between upside and downside implied in their forecasts. Here is what the 60-odd short ETFs' prices have done in the 80 market days (16 weeks or near 4 months) following the 54,164 daily forecasts available from them in the 4 ½ years from 6/3/2009 to 12/3/2013.

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Wow! That's not very encouraging to anyone used to making long investments hoped to rise in price. This table, on its mid-level blue line that is the average for all of the short ETFs in this period, says that typically a decline of -13% is encountered in less than 4 months, or an annual rate of worse than -40%.

The rows in the table are arranged from, at the top, those forecasts with the most upside-to-downside proportions, and from the bottom, those with the opposite, most downside-to-upside. So it seems that within this bleak environment, as length of time after the forecast progresses, the ones with the largest downside forecasts do tend to see the most declines, and the ones with the least-proportion downsides have declines out at the 80-day holding period significantly less than the average.

And there is some encouragement in that the forecasts with the most upsides actually do show some slight positive price gains in the first week or two.

But a 4+ year average of a mostly-gaining market is not what these ETFs are about. And the sharpies playing their game do not hang around all the time to lose money at that rate. Instead, let's look at what happens to the prices of these ETFs during periods that we know should be favorable to them. Like the second quarter of 2012, when the S&P500 dropped -12% in just a couple of months. It gives us a very different picture:

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Here the time period of 3/26/12 to 5/29/12 shows an average price gain of +16% in the two months (40 market days) that the SPX dropped -12%. Nearly all the price experiences of forecasts with more downside than upside had declines, while those with more upside prospects showed gains consistently.

Significantly, of the 2098 forecasts available in those 40 days, 1739 of them, or some 85%, had a positive outlook. Less than 3% were negative on balance in their forecasts.

So, what have we got to work with for trade candidates from these ETFs at the present time? There are bound to be some that the market pros have a better understanding of than the others. They may be the safer ones to work with, if any adventures of this type are attempted.

We have a standard test we apply to all investment candidates, and it fits even these short-term trades. We look at each candidate's past forecast record, and extract only those where the upside-to-downside balance is similar to its present forecast. Then we see how often the top of their forecast range is achieved, how quickly, in the next 3 months. If not reached, we close out hypothetical positions at whatever the market price is at that point and see what the average gains have been on all such forecasts, how much time of capital commitment was required, and the average annual rate of gain involved.

We also look to see what the worst drawdown was in each forecast situation, and take an average of those as a measure of the risks encountered, even if no loss was taken, since stress is a cost of doing this business. In addition, the percentage of winning (profitable) experiences from all of such prior forecasts gives a measure of confidence in the success of the next such adventure.

Here is a list of the potential candidates, ranked by their past odds of winning, subsequent to forecasts like those of the present. A quick look at the annual rates of gain will show a close parallel in ranks to those winning odds.


Each investor needs to draw their own boundaries and tradeoffs in capital ventures of this sort. We make no recommendations, but simply hope to provide useful perspectives. SPY is offered as a market comparison.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.