Short Cut to Profits? A Closer Look at Inverse Funds

by: Richard Shaw

With all the gloom and doom in markets today, more people are thinking about trying to benefit from the price declines.

Futures and options are an alternative, as is short selling.  All of those pose significant knowledge and experience hurdles for many investors.

Short index mutual funds and short index ETFs (also called “inverse” funds) have grown in popularity and assets recently,  They provide a more convenient and easily accessible path to seeking gains in declining markets.

Those funds are expanding short exposure opportunity from the professional world to the retail world — for better or worse only time will tell.  Short exposure is now far more accessible and usable to retail investors than it ever was before.  No longer must the investor be wealthy enough to qualify for a hedge fund, endure the low transparency and illiquidity of hedge funds and incur the high annual and profit sharing fees of hedge funds.

For sure, ability to access short exposure is not a guaranteed route to gains.  Even the pros have had some tremendous losses with shorts.

Caution: We are not recommending short exposure, but we are seeking to shed some light on this area of fund proliferation.

Short (or inverse) exposure, even with diversified index funds, is probably not a good idea for most investors.  It requires more attention at shorter intervals than long index exposure, which in theory can be left alone for longer periods of time with less attention, if investment time horizons are also long.

Short index exposure left unattended will in most cases ultimately result in losses, because over time most market indices have an upward bias.

In the short-term, however, a short exposure through index funds could be profitable in strongly down trending markets such as we have today, for those who are careful, nimble and attentive.

General advice for do-it-yourself investors — don’t take inverse index exposure unless you are an experienced investor, well informed about the markets and trends, and stay closely on top of your investments, preferably with some help from your advisor.

Ten Important Features of Inverse Funds:

Inverse (short) funds have several important features that set them apart from futures, options and traditional shorting:

  1. You don’t actually go short — you go long the inverse fund (the fund goes short)
  2. You can’t lose more than the price you paid
  3. You don’t need to be cleared for options trading by your broker
  4. You don’t need a separate futures account with a futures dealer
  5. You don’t need a margin account (you can purchase them in a “cash” account)
  6. If you don’t buy on margin, you won’t incur interest cost (traditional shorting exposes you to interest costs)
  7. Because you take long positions in inverse funds, you can purchase them in IRA’s (you cannot do traditional shorting, or use options or use futures in an IRA)
  8. You don’t have to learn the complex workings of options and futures
  9. There is no expiration date on your position as with options and futures
  10. Price charts are readily available, but are not for options

Washington D.C.

Last week Washington banned shorting certain financial stocks.  As a result, the inverse financial sector fund ETFs are not currently creating new shares.  That sector is out of bounds for now.

Here is a quote from the updated Rydex inverse financial sector prospectus:

Recent market events, including the emergency action announced by the Securities and Exchange Commission on September 18, 2008, temporarily prohibiting short sales of shares of certain financial companies, has had the effect of restricting the Adviser’s ability to employ certain swaps, futures and options, as well as short sales, in its investment strategy.  Consequently, the Adviser has been forced, and may continue to be forced, to implement alternative investment strategies to seek each Fund’s investment objective.  As a result, during this period of continued market unrest, each Fund is likely to have higher than normal tracking error.  Nonetheless, the Adviser will continue to make every effort to seek to achieve each Fund’s investment objective, but can give no assurances that it will be able to do so.

Important Comment/Translation: They are currently prohibited from dealing in creation units (the price-to-NAV arbitrage mechanism) that keeps the share price close the the NAV.  Current holders of inverse financial sector ETFs, regardless of issuer, may well see large discounts or premiums to NAV until and unless the issuer can resume the creation unit (arbitrage) process.  Inverse financial sector funds will trade like closed-end funds which have no arbitrage mechanism to keep market price and NAV close together.  When/if their derivatives expire, they will become less and less short, until they are just a cash fund, if the rules don’t change.  Traditional shorts they may put on prior to the ban can remain in place.

Given the events of the last couple of weeks, it is probably safe to say that virtually anything can happen with regulations, and nobody knows from day-to-day what will change or how.

For all we know, regulations could come out that effectively destroy the viability of retail inverse funds  — no reason to believe it will happen, but things are changing all around us.

US Dollar Index Example:

The exchange value of he US Dollar against a trade-weighted basket of currencies is one example of a long / short pair opportunity.  There is a long (bullish Dollar - (NYSEARCA:UUP)) and short (bearish Dollar - (NYSEARCA:UDN)) ETF for that index.

If you observe the Dollar rising in value against other currencies and believe that it will continue, you might own UUP.

If you observe the Dollar declining in value and believe that will continue, you might own UDN.

Those two ETFs are an example of a long / short pair that make it possible to be in the market for Dollars with the expectation of gain whether the Dollar is rising or falling.

They move inversely to each other as the chart below illustrates:

click images to enlarge

The inverse price movement is pretty good with this pair, but that is not always the case with other pairs.  Some are better than others, as we shall see.

Imperfect inverse correlation is tracking error, due in great part to failure of inverse representative sampling as opposed to inverse index replication, and the use of volatile derivatives instead of traditional shorting to track the target inverse index.

How the Inverse Funds Invest (they don’t just short stocks):

They all use derivatives as the core of their investment strategy.  They take in assets, invest them in US government securities that are good collateral for their derivative trades.  They earn interest on the collateral to pay or help offset expenses and their management fees.

  • Powershares bearish Dollar ETF sells Dollar index futures contracts
  • ProShares inverse ETFs uses sampling to inversely approximate (track) the particular index for each ETF, including futures, options on futures, swap agreements, forward contracts, and options on individual securities or indices.
  • Rydex inverse ETFs presumably use sampling, and engage in a combination of short sale of stocks and use of leveraged derivative products, including techniques such as equity index swaps, futures contracts, and options on securities, futures contracts, and stock indices.

How Inverse Funds Might Be Used:
(Note: these examples are not recommendations, just illustrations)

Directional Bet: If you are strongly convinced of your views, you could take a “directional bet” and simply buy an inverse fund for the asset category you think will go down (i.e. inverse US Dollar index or inverse S&P 500 index).

Differential Bet: If you strongly believe that one class will rise and another will fall, you could take a long position in long funds for the categories you think will rise and take a long position in a short fund for the categories you think will fall (i.e. long XLP for consumer staples, and long the short fund SIJ for industrial companies).

Hedged Bet: If you feel strongly that a sub-category of a larger index will fall, while the larger index will rise, you might attempt to increase return by going long a long fund for the larger index while going long a short fund for the sub-index (i.e. long the long fund SPY for S&P 500 and long the short fund DUG for energy, if you thought energy was going to fall). You could also hedge out some currency risk from a long equity index using UUP or UDN.

Representative Long / Short Fund Pairs:

The table below provides a list of passive index categories with corresponding long and inverse (short) passive index ETF funds.  There are alternative long and inverse ETFs available for some of these categories.

The 2X (double) inverse type of short fund is more prevalent than the 1X inverse fund type.  If the degree of leverage is too much and a 1X inverse fund is not available, it might be reasonable to use a smaller amount of a 2X inverse fund to achieve the same effect as using a 1X fund.

We maintain a list of 2X inverse funds on our website, and weekly we update the performance of those funds over 1-week, 4-weeks, 13-weeks, 26-weeks, and 52-weeks.  (see 2X inverse list).

There are fewer 1X inverse funds than 2X inverse funds.  A weekly updated performance listing for those is available at our website (see 1X inverse list).

There is also a significant number of no-load short mutual funds (a few actively managed, but most passive) that could also be of interest.  We update performance for that group weekly as well (see mutual fund list).

Visual Chart Comparisons for Long and Short Fund Pairs:

The following images of 1-year candlestick charts show the long fund on the top row and the corresponding short fund immediately below the long fund in the second row, to provide a visual indication of just how closely inverse they are or are not.

click images to enlarge

The listing of 2X inverse ETFs on our site, also has links to the pair charts above, which are updated daily by

Before you begin using inverse funds, even if you are an experienced investor, it probably makes good sense to talk with someone whose judgement you value about the strategy you plan to implement, just in case you missed something.  Two heads are better than one when embarking on a new path.

Be careful.