You’ve heard it before: an Exchange Traded Fund (ETF) is a way to “buy the market,” and to passively grab returns without chasing Alpha. It’s an investment that’s supposed to be boring and good (or perhaps good because it’s boring, as is commonly said of investments). But ETFs are a lot more diverse than you suspect, and today we’re going to look at one that turns the whole thing upside-down. Literally.
What is an inverse ETF?
The simplest description is an ETF that produces returns opposite to the underlying security / index. In a conventional ETF, if an underlying index moves up one per cent, you’d expect the fund to move up 1%. In an inverse ETF, the fund would go down 1%.
Why would you do that? The answer would market downturns. During recessions, for example, you’d expect an index like the STI, the S&P 500, the HSI, etc., to go down. But if you have an inverse ETF, you’re gaining when the indexes are dipping. This is the financial tool for someone so ballsy, they don’t just want to avoid the downturn; they want to profit from it.
That’s why an inverse ETF is also colloquially referred to as a bear ETF. This is a tool you use when you’re certain that the market is in for rough times.
Mind you, this also makes inverse ETFs quite risky: if you predict wrongly and the market goes up instead, this means a loss for you. There’s also the issue of volatility losses (see below), so it’s uncommon for investors to hold inverse ETFs for more than a day.
Leveraged inverse ETFs
These are ETFs that amplify returns and losses. For example, a double (2x) inverse ETF means that, if the underlying index or security moves down 1%, the fund would be up 2%.
Needless to say, leveraged ETFs significantly amplify the risks involved. Leveraged ETFs are notfor investors with a heart condition, or who want to avoid developing one.
How does it work?
On the surface this looks like it’s just flipping an ETF upside down; but the mechanics of it are much more complex. The inverse ETF is a form of actively managed fund. Behind the scenes, a manager is using derivatives like options, swaps and futures, to derive profits when a particular asset drops in price (i.e., they’re betting against the relevant assets).
Unlike a regular ETF, which can just be a computer following an algorithm, someone is behind the scenes handling all the various contracts. This sort of frequent treading will always result in higher fund expenses, often 1% or more.
(By contrast, the fees for an ETF can even fall below 0.3%).
The risks behind inverse ETFs
Volatility losses are the most obvious issue with inverse ETFs. When you hold an inverse ETF for more than a day, you may find a disparity between the returns and the underlying index. For example:
Say you buy an inverse ETF for $10, against a security worth $10.
On the first day the security dips 5% as you expected. Your inverse ETF goes up 5%. The security is now at $9.50, and your inverse ETF is at $10.50.
You then decide to hold for another day. This time the security drops another 10% to $8.55. Your inverse ETF goes up 10% to $11.55.
You hold again, and on this third day the security swings up 10%. The security is at $9.40, while your ETF goes up to $10.39.
The security is down ($10 – $9.40) = 6% from its initial value, but your inverse ETF is only up ($10 + $0.39) 3.9% from its initial value.
So on day one, the movement of your ETF correctly mirrored the movement of the underlying security; they both moved 5%. But held for up to three days, there’s a notable disparity.
This is why inverse ETFs are rarely held for any length of time. Quite often, they’re held for no longer than a single day.
All this sounds a lot like short-selling
The main difference is that short-selling has no theoretical loss limit. With inverse ETFs, the absolute worst that can happen is that your go to zero. This means you’ll at least know the maximum amount you can lose (i.e., however much you put into the reverse ETF).
There may also be situations where you can’t open a margin account, that’s needed for shorting. But I’m going to go out on a limb and say that, if for some reason you’re not allowed to have a margin account, you very probably aren’t the sort of investor who should be looking at inverse ETFs either.
Inverse ETFs are not the simplest tools, and are best used by more seasoned investors. There are only a handful of times I’ve ever heard a wealth manager bring these up, and even then it was for their more financially sophisticated clients.
Bear ETFs do have their use; but if you should stumble upon them, don’t be too eager to use them without the necessary insights (i.e., talk to a financial professional first). For more on unusual or interesting financial tools, follow us on Single Digit Millionaire.
