Exchanged-Traded Funds (ETFs) are generally good investment vehicles for investing in stocks and equities. But some can also be used to profit when stocks go down, such as during the current market downturn due to COVID-19. ETFs that are short stocks or are based on a negative index can increase in value when their underlying assets go down in price. These are called Inverse ETFs. Inverse ETFs are designed with speculative investors and traders in mind and are designed to profit during a bear market when there is a price decline in specific stocks, commodities, or targeted indexes. The main advantage of Inverse ETFs compared to traditional shorting is that your maximum loss is limited to your initial investment; an inverse ETF can only go to zero whereas a direct short can have an unlimited loss. A well-informed investor can take advantage of inverse ETFs to make a profit even during the downturn.
How do Inverse ETFs work?
This category of ETFs seeks investment results that are the inverse of a certain benchmark’s (like an index) performance. They can use direct shorts or derivative instruments like futures and swaps to achieve their goals. Most inverse ETFs reset daily, which means the value of the ETF changes based on the daily percentage changes on the index.
Risks Associated with Inverse ETFs:
In general, there are some risks associated with inverse ETFs such as compounding risk, short sale exposure risk and correlation risk.
Compounding Risk: When leveraged inverse ETFs are held for longer than one day, the fund’s performance is likely to suffer and mitigating this risk requires a lot of active management of the ETF. In periods of high volatility, this risk becomes a lot more prominent.
Short Sale Exposure Risk: Since inverse ETFs often seek short exposure using derivative securities like futures contracts and swaps, the ETF funds are exposed to risks associated with short selling securities. These derivatives can be highly illiquid and volatile, and the fund may have to buy back its short position in an unbalanced market. This risk is not significant for inverse ETFs that target indexes (i.e. baskets of several equities or bonds) where there is much higher liquidity.
Correlation Risk: Most Inverse ETFs rebalance their portfolios daily leading to higher transaction costs. Additionally, repeated rebalancing of stock portfolios means inverse funds might be either over- or under-exposed to benchmarks thus decreasing the inverse correlation between the inverse ETF and underlying indices.
As well, futures contracts, which inverse ETFs often use, are derivatives with a predetermined delivery date of an underlying security or its monetary equivalent. Funds roll their positions into further-dated less expensive future contracts in times of backwardation (i.e. when current prices of underlying assets are higher than prices trading in the futures market), and roll them into more-expensive further-dated futures in contango markets (when futures contract price is higher than the spot price).
These constantly changing positive and negative roll yields make it very difficult for inverse ETFs to have perfect correlations to underlying indexes on a daily basis and puts them more at risk of loss.
Leveraged Inverse ETFs
Inverse ETFs can either be leveraged or non-leveraged. Leveraged inverse ETFs go up by 2 or 3 times the degree of their index’s downward movement. For example, if the market goes down by 2%, a leveraged inverse ETF can go up by up to 4% (-2X) or 6% (-3X). The inverse would happen if the market goes up – the leveraged inverse ETFs would drop by double or triple the increase. Typically, any leveraged investment such as investments in real estate with mortgages involves borrowing to get the extra exposure. This can mean additional costs that drag on your potential return. This combined with the risk of leveraged ETFs to suffer in periods of volatility make them more suited for short term trading rather than long-term investing.
As high as the potential gains of leveraged inverse ETFs are, they are unsuitable for risk-averse investors and better suited to risk-tolerant, well-experienced investors because of the numerous risks. Generally, most investors should avoid them. However, non-leveraged inverse ETFs can be used by average investors since they are associated with lower risks and they don’t lose money by volatility.
To understand how leveraged inverse ETFs can lose value despite decreases in their index, let’s assume a inverse leveraged ETF of (-2X) with net asset value (NAV) of $100 that follows the two times inverse movement of an index that currently is around 20. If the index jumps to 24 the next day and then back to 20 while the underlying value doesn’t change, the ETF would lose value. Why?
When the underlying index goes from 20 to 24 the underlying is increasing by 20%; this means that the inverse leveraged ETF value decreases by 40% so it becomes $60 (from $100). Then the next day when the price goes down from 24 to 20 the decrease is 16.7% this means that the inverse leveraged ETF value will jump close to 33.4% which makes its value $80. So while the underlying index didn’t change, the value of the inverse leveraged ETF decreased 20% because of the volatility and daily reset!
We can see this happening in real-life with a -3X S&P500 inverse ETF like the Direxion Direxion Daily S&P 500 Bear 3X Shares (SPXS). Due to the COVID-19 pandemic, stock indexes have recently fallen significantly, but due to the high volatility inverse ETFs have not been as profitable as they would seem to be. On March 2nd, 2020, SPXS was valued at $14.42 per unit and the S&P500 index was at 3090.23. On April 1st, SPXS was at $18.09 and the S&P500 index was at 2470.50. In one month, despite the S&P500 losing around 20%, SPXS’s value only increased by 25.45%.
The combination of the risks of inverse ETFs makes it very difficult for the average investor to invest safely in them. But still they are very good products that can help you profit from the market downturns. Inverse ETF investments are best on a short-term basis when you know the market is going down, but should not be kept for a long period of time where fluctuations can quickly degrade their value.