What Are They?
- Inverse Sector ETFs aim to provide the opposite performance to their benchmark, ie. the same effect as shorting the stocks in a sector index. An inverse sector ETF, therefore, is a negative bet on the sector index and aims to provide a daily percentage movement opposite to it. So if the sector index rises by 1%, the inverse sector ETF should fall by 1%; and if the sector index falls by 1%, the inverse sector ETF should rise by 1%.
- Leveraged Inverse ETFs aim to provide some multiple of the opposite performance to their benchmark. The ProShares UltraShort Utilities ETF, for example, aims to provide double the opposite performance to the utilities sector index. So if the utilities sector index rises by 1%, the leveraged inverse ETF should fall by 2%; and if the utilities sector index falls by 1%, the inverse ETF should rise by 2%.
- The PowerShares inverse and leveraged inverse ETFs use futures instead of short positions in stocks. Because futures provide leverage (more exposure than the actual cash invested), ETFs that use futures contracts have uninvested cash, which they usually park in interest-bearing bonds. The interest on the bonds is used to cover the expenses of the ETF and to pay dividends to the holders.
Why & How To Use Them
- Possible reasons to short an index: (1) A long term investor has an illiquid position in a stock or group of stocks, and wants to be protected against a market decline. (2) A long term investor believes the market will fall, and has a large unrealized capital gain that he/she doesn't want to realize. (3) A short term trader wants to make a bearish bet on the market.
- Reasons to short a sector index: (1) A long term investor has an illiquid position in a single stock, and wants to be protected against a market decline. (2) An individual wants to hedge his job exposure (see Further Reading below). (3) A short term trader wants to make a bearish bet on a specific sector. (4) A long term investor believes the market will fall, and has a large unrealized capital gain in a single stock or sector that he/she doesn't want to realize.
- Inverse ETFs and leveraged inverse ETFs may have tax advantages over shorting stocks. An investor owning a futures-based ETF is taxed on any capital gains on the underlying futures held by the fund using the taxation convention for futures, ie. at a hybrid rate of 60% long-term, 40% short-term each year on all gains, even if the investor doesn't sell the fund. (Check this carefully with your accountant.) In contrast, all gains on short stock positions are taxed as short term capital gains.
- Inverse ETFs may have specific advantages for bearish non-professional investors over shorting index ETFs: (1) Inverse ETFs may be purchased in individual retirement accounts [IRAs]; whereas investors may not short stocks or ETFs in IRAs. (2) Many retail investors have margin accounts that don't pay interest on short balances (the cash generated from selling short a stock or ETF). Purchasing an inverse ETF may therefore turn out to be financially preferable to shorting an index ETF. (3) Purchase of an inverse ETF exposes the investor to limited losses -- the most you can lose is the entire value of the inverse ETFs. Shorting a stock or ETF, in contrast, exposes the investor to potentially unlimited losses.
What to Look Out For
- Inverse and leveraged inverse ETFs tend to have higher expense ratios than standard index ETFs, even proportionate to the level of exposure.
- Leveraged ETFs (in this case leveraged short ETFs) may perform poorly in flat markets, and can underperform their benchmarks in conditions of significant volatility. See Further Reading below.
- Futures-based ETFs may suffer from greater tracking error (ie. divergence from the target benchmark index) than traditional index ETFs because futures are intrinsically harder to manage than stocks.
- For a discussion of hedging job exposure, see ETF Investing Guide: Was Peter Lynch Really Right?.
- Discussion of short ETFs: Tax Advantages of Inverse ETFs Not So Clear (Eli Hoffman), A Closer Look at the ProShares Inverse ETFs (Investing the Middle Way), Leverage and Inversion: A New Look for ETFs (Brad Zigler), UltraShort ProShares ETFs: 24 Ways to Benefit From Going Short (Stockerblog).
- On leveraged inverse ETFs: Tristan Yates and Lye Kok discuss the risk that leveraged ETFs will produce sub-par long term performance in Leveraged ETFs: A Value Destruction Trap? and The Case Against Leveraged ETFs. Christopher Baldwin also comes out against leveraged ETFs in Clear Proof Against Leveraged ETFs.
- Uses of leveraged ETFs are discussed in Leveraged ETFs For Upside Juice and Downside Protection and in Brad Zigler's Leverage and Inversion: A New Look for ETFs.
This page is part of The Seeking Alpha ETF Selector which sorts ETFs by type, highlights how to use them and what to look out for, and provides links to articles that discuss key issues for investors.