How Inverse ETFs Can Help and Hurt You

A recurring question I get from readers is especially pertinent in turbulent market times like these.

The gist of the question is this: in an Individual Retirement Account (IRA), if you think the stock market is going down, how can you bet against the market?

Since the government won’t permit borrowing in an IRA, you can’t trade on margin, so shorting is out of the question. Sure, you can buy puts, but what if you aren’t comfortable with options?

Inverse ETFs: Opposite of the Benchmark

There is a simple way to bet against the market without using margin, and that’s through an inverse exchange-traded fund (ETF).

Typically, the goal of an inverse ETF is to track an underlying benchmark’s daily return on a percentage basis, but inversely.

In other words, if the benchmark gains 1% on Day 1, the inverse ETF should fall approximately 1%. And if the benchmark loses 0.5% on Day 2, the inverse ETF should gain about 0.5%.

There are also leveraged inverse ETFs that aim to return two or three times the opposite return of the benchmark. In the example above, a 2x inverse ETF should return about -2% on Day 1 and +1% on Day 2.

Effective Short-Term Bets

Inverse ETFs work through the trading of derivatives like futures and swaps to try to match its daily goal. Leveraged inverse ETFs also borrow money. The fund managers do a remarkably good job of achieving their intended return everyday.

If you want to bet against the market for a short period of time, inverse ETFs can work well.

The table shows the daily return of the S&P 500 compared to ProShares Short S&P500 (SH) and ProShares UltraShort S&P500 (SDS). SH is a straight-forward inverse ETF; SDS is a 2x inverse ETF.

The S&P 500 hit its all-time high on February 19, then booked losses for seven days in a row. As the table shows, the cumulative loss over those seven days was 12.8%. SH closely tracked the S&P 500 inversely everyday. At the end of seven days, the return was 14.2%.

SDS, the leveraged inverse ETF, did even better. Its seven-day return was 29.3%, significantly better than twice the S&P 500’s loss!

Proceed With Caution

Before you run out and get yourself some inverse ETFs, though, there are caveats. Remember that I said earlier that inverse ETFs can work well over a “short period of time?”

That’s the key. These inverse ETFs should be treated as a trading vehicle, not as a long term investment.

If we take a step back in time and look at how these two ETFs performed over a longer period, we will start to notice a problem. The table shows the values of the S&P 500 and the two ETFs on March 20, 2019 and on March 20, 2020. (The March 20, 2019 prices are adjusted for dividends paid.)

The S&P 500 fell 18.4% over the past year. Meanwhile, SH gained 15.7%. Not as much as you might expect, but still not too bad. But if we look at SDS, its gain was only 22.4%, nowhere near twice the inverse of the S&P return!

No matter how well an inverse ETF tracks the benchmark each day, over time there will be deviation from the intended result. The longer the ETFs are held and the higher the leverage, the greater the difference will be.

Volatility: Not Good for Leveraged ETFs

Consider SDS. At the beginning of every trading day the fund managers borrow money to keep the leverage at 2x in order to maintain its strategy. After a winning day for the fund (a losing day for the S&P), the fund will borrow more money to keep the 2x leverage. And after a losing day, the fund returns some money to also keep leverage at 2x.

This would actually work in the fund’s favor if the S&P 500 falls for consecutive days, as in the seven-day example we gave above. The reason is that when you borrow money to keep the leverage at 2x after a good day, you increase market exposure right before another good day so the return is higher.

But this doesn’t work over a long period of time because the S&P 500 is bound to have periods where it fluctuates rather than decidedly head downward as we’ve seen lately.

Consider what would happen if the S&P 500 gains in Day 1, falls in Day 2, and then gains in Day 3. What happens in this scenario is that the leveraged inverse fund would fall on Day 1, and return borrowed money before Day 2 to keep the leverage at 2x.

However, that hurts the performance because it reduces market exposure on a day when it goes up. Then before Day 3, the fund would borrow money to maintain a 2x leverage, but this again backfires because it increased market exposure on a bad day. Thus, when the stock market has a lot of oscillation, the leveraged inverse ETF’s performance will slip.

Percentages Can Hurt You

SH doesn’t use leverage so it’s better in that regard, but it still uses derivatives and perfect tracking is not possible. Also, the way percentages work will hurt an inverse ETF. Consider the next table.

The table shows a hypothetical benchmark and an inverse ETF that tracks it perfectly everyday for 10 days. But at the end of the 10-day period, while the benchmark shows no change, the inverse ETF actually lost 0.27%! The difference may seem small to you, but over time this deviation can build up.

You see, when you fall X% from A to B, in order to get back to A from B, you will need a greater gain than X%. In other words, if you fall 2% from 100 to 98, to get back to 100, you need a 2.04% gain. Since an ETF tracks the benchmark in percentage terms, you can see why it would suffer from this.

Also, due to the additional trading and work required, an inverse ETF will charge relatively high fees for an ETF. For example, SH and SDS both have expense ratios of 0.89%. The SPDR S&P 500 ETF (SPY), a popular ETF that tracks the S&P 500 on a 1:1 basis, has an expense ratio of only 0.095%.

The bottom line is that inverse ETFs can help you during rough times for the market, but don’t get wedded to them and hold them for too long.

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