Inverse exchange-traded fund
An inverse exchange-traded fund is an exchange-traded fund (ETF), traded on a public stock market, which is designed to perform as the inverse of whatever index or benchmark it is designed to track. These funds work by using short selling, trading derivatives such as futures contracts, and other leveraged investment techniques.
By providing, over short investing horizons and excluding the impact of fees and other costs, performance opposite to their benchmark, inverse ETFs give a result similar to short selling the stocks in the index. An inverse S&P 500 ETF, for example, seeks a daily percentage movement opposite that of the S&P. If the S&P 500 rises by 1%, the inverse ETF is designed to fall by 1%; and if the S&P falls by 1%, the inverse ETF should rise by 1%. Because their value rises in a declining market environment, they are popular investments in bear markets.
Short sales have the potential to expose an investor to unlimited losses, whether or not the sale involves a stock or ETF. An inverse ETF, on the other hand, provides many of the same benefits as shorting, yet it exposes an investor only to the loss of the purchase price. Another advantage of inverse ETFs is that they may be held in IRA accounts, while short sales are not permitted in these accounts.
Because inverse ETFs and leveraged ETFs must change their notional every day to replicate daily returns (discussed below), their use generates trading, which is generally done at the end of the day, in the last hour of trading. Some have claimed that this trading causes increased volatility (Cheng & Madhavan 2009), while others argue that the activity is not significant.
Fees and other issues
Inverse and leveraged inverse ETFs tend to have higher expense ratios than standard index ETFs, since the funds are by their nature actively managed; these costs can eat away at performance.
Short-terms vs. long-term
In a market with a long-term upward bias, profit-making opportunities via inverse funds are limited in long time spans. In addition, a flat or rising market means these funds might struggle to make money. Inverse ETFs are designed to be used for relatively short-term investing as part of a market timing strategy.
An inverse ETF, like any leveraged ETF, needs to buy when the market rises and sell when it falls in order to maintain a fixed leverage ratio. This results in a volatility loss proportional to the market variance. Compared to a short position with identical initial exposure, the inverse ETF will therefore usually deliver inferior returns. The exception is if the market declines significantly on low volatility so that the capital gain outweighs the volatility loss. Such large declines benefit the inverse ETF because the relative exposure of the short position drops as the market fall.
Since the risk of the inverse ETF and a fixed short position will differ significantly as the index drifts away from its initial value, differences in realized payoff have no clear interpretation. It may therefore be better to evaluate the performance assuming the index returns to the initial level. In that case an inverse ETF will always incur a volatility loss relative to the short position.
The volatility loss is also sometimes referred to as a compounding error.
If one invests $100 in an inverse ETF position in an asset worth $100, and the asset's value changes the first day to $80, and the following day to $60, then the value of the inverse ETF position will increase by 20% (because the asset decreased by 20% from 100 to 80) and then increase by 25% (because the asset decreased by 25% from 80 to 60). So the ETF's value will be $100*1.20*1.25=$150. The gain of an equivalent short position will however be $100–$60=$40, and so we see that the capital gain of the ETF outweighs the volatility loss relative to the short position. However, if the market swings back to $100 again, then the net profit of the short position is zero. However, since the value of the asset increased by 67% (from $60 to $100), the inverse ETF must lose 67%, meaning it will lose $100. Thus the investment in shorts went from $100 to $140 and back to $100. The investment in the inverse ETF, however, went from $100 to $150 to $50.
An investor in an inverse ETF may correctly predict the collapse of an asset and still suffer heavy losses. For example, if he invests $100 in an inverse ETF position in an asset worth $100, and the asset's value crashes to $1 and the following day it climbs to $2, then the value of the inverse ETF position will drop to zero and the investor would completely lose his investment. If the asset is a class such as the S&P 500, which has never increased by more than 12% in one day, this would never have happened.
For instance, between the close of November 28, 2008 and December 5, 2008, the iShares Dow Jones US Financial (NYSE: IYF) moved from 44.98 to 45.35 (essentially flat, properly an increase of 0.8%), so a double short would have lost 1.6% over that time. However, it varied greatly during the week (dropping to a low of 37.92 on December 1, a daily drop of 15.7%, before recovering over the week), and thus the ProShares UltraShort Financials (NYSE: SKF), which is a double-short ETF of the IYF moved from 135.05 to 117.18, a loss of 13.2%.
Given that the index follows a geometric Brownian motion and that a fraction of the fund is invested in the index , the volatility gain of the log return can be seen from the following relation.
where is the variance of the index process and the last term on the right hand side constitutes the volatility gain. We see that if or , as is the case with leveraged ETFs, the return of the fund will be less than times the index return (the first term on the right hand side).
List of funds
Some inverse ETFs are:
- Boost 3X Short Gold - LSE: 3GOS
- Boost 3X Short Silver - LSE: 3SIS
- Boost 3X Short Nat Gas - LSE: 3NGS
- Boost 3X Short Copper - LSE: 3HCS
- Boost 3X Short WTI - LSE: 3OIS
- Boost 3X Short FTSE100 - LSE: 3UKS
- Boost 3X Short S&P 500 - LSE: 3USS
- Boost 3X Short Nasdaq 100 - LSE: QQQS
- Boost 3X Short Dax - LSE: 3DES
- Boost 3X Short Eurostoxx50 - LSE: 3EUS
- Direxion Financial Bear 3X - NYSE: FAZ
- Direxion Technology Bear 3x - NYSE: TYP
- Direxion Russell 1000 Bear 3x - NYSE: BGZ
- Direxion Russell 2000 Bear 3x - NYSE: TZA
- Direxion Russell MidCap Bear 3x - NYSE: MWN
- ProShares Short Dow 30 - NYSE: DOG
- ProShares Short S&P 500 - NYSE: SH
- ProShares Short S&P MidCap 400 - NYSE: MYY
- ProShares Short S&P SmallCap 600 - NYSE: SBB
- ProShares Short Nasdaq 100 - NYSE: PSQ
- ProShares Short Russell 2000 - NYSE: RWM
- ProShares S&P 500 Bear 3x - NYSE: SPXU
- HBP S&P/TSX 60 Bear Plus ETF - TSX: HXD
- HBP S&P/TSX Capped Energy Bear Plus ETF - TSX: HED
- HBP S&P/TSX Capped Financials Bear Plus ETF - TSX: HFD
- HBP S&P/TSX Global Gold Bear Plus ETF - TSX: HGD
- HBP S&P/TSX Global Mining ETF - TSX: HMD
- HBP NYMEX Crude Oil Bear Plus ETF - TSX: HOD
- HBP NYMEX Natural Gas Bear Plus ETF - TSX: HND
- HBP COMEX Gold Bullion Bear Plus ETF - TSX: HBD
- HBP S&P500 Bear Plus ETF - TSX: HSD
- HBP NASDAQ-100 Bear Plus ETF - TSX: HQD
- HBP U.S. Dollar Bear Plus ETF - TSX: HDD
- HBP MSCI Emerging Markets Bear Plus ETF - TSX: HJD
- HBP DJ-AIG Agricultural Grains Bear Plus ETF - TSX: HAD
- HBP U.S. 30yr Bond Bear Plus ETF - TSX: HTD
- Boost ETP
- ETF Securities
- Horizons ETF
- List of exchange-traded funds: leveraged & short ETFs
This article includes a list of references, but its sources remain unclear because it has insufficient inline citations. (March 2009) (Learn how and when to remove this template message)
- Weinberg, A. I., "Should You Fear the ETF?", The Wall Street Journal, Dec 6, 2015.
- Anon., “How Do Inverse ETFs Work?”, The Motley Fool, Jun 22, 2016.
- "Inverse Bond Treasury ETF Nears Breakout - Yahoo Finance". Yahoo! Finance.
- Marketwatch article on inverse funds
- Pozen, R., & Hamacher, T., The Fund Industry: How Your Money is Managed (2nd ed.) (Hoboken: Wiley, 2015), pp. 390–392.
- Cheng, Minder; Madhavan, Ananth (2009-04-08), The Dynamics of Leveraged and Inverse Exchange-Traded Funds (PDF), Barclays Global Investors
- Will Leveraged ETFs Put Cracks in Market Close?, by Jason Zweig, Wall Street Journal, discussing Cheng & Madhavan report