What’s become very popular in recent years is a form of exchange-traded fund (ETF, a mutual fund that trades on an exchange) that tracks the inverse of a given index. If the index goes up, the ETF goes down, and vice-versa.
ProShares brought a series of inverse ETFs to market in 2006. Their double short (2X) inverse ETFs, which magnify price movement of the underlying index by two, quickly became popular. Seeing the possibilities, in November 2008, Direxion, another sponsor, introduced 14 inverse ETFs designed to move three times the amount (3X) of the underlying index. The market lapped them up. Not to be outdone and to take advantage of the popularity, ProShares brought numerous 3X ETFs to market in the summer of 2009. Between these two sponsors, there are now more than 80 ETFs designed to magnify the movement of an index, covering a wide range of equity, fixed income and commodity markets.
Three factors contribute to the popularity of inverse ETFs. First, because they trade like stocks, they are, at least superficially, easy to understand. Second, they impose relatively low costs. Third, unlike other hedging vehicles such as futures, options and short-selling, you can use them in IRA accounts. What could be simpler—hedge your market exposure with the simple purchase of an inverse ETF that magnifies the movement of the index you use as your performance benchmark.
Here’s how one might employ an inverse ETF. Assume you hold a portfolio of well-researched and diversified stocks that’s been handily outperforming the S&P 500. You’re concerned the stock market is heading for a rough period. So, instead of holding 100 percent of your IRA in stocks, you pare back your holdings to 75 percent. With the remaining 25 percent, you purchase a 3X inverse S&P 500 Index ETF. Simple arithmetic leads you to conclude that, assuming your stock holdings continue to perform at least as well as your benchmark S&P 500 Index, the worst you will do is break even if the market crashes, right?
Wrong.
The key to the toxicity of inverse ETFs is that they’re designed to match the daily movement of the underlying indexes. If the S&P 500 goes down 1 percent today, the 2X inverse ETF will rise 2 percent and the 3X will gain 3 percent. So far so good.
Albert Einstein said, “The most powerful force in the universe is compound interest.” When applied to volatile returns, however, compounding works against the investor. And the more volatile the returns, the worse the result.
Let’s look at a simple example. If you purchase a 10-year certificate of deposit for $1,000, yielding 5 percent compounded annually, at the end of the term, you’ll have $1,629, representing the equivalent yield of 6.29 percent simple interest. Your compounded returns are better than your annual rate because the yearly returns are steadily positive. Let’s see what happens if the returns are volatile instead. If the volatility is equal to the amplitude of the returns (plus or minus 5 percent), the average annual return from your CD drops to 6.11 percent, a drop of $19 in your total return.
Historically, the volatility of stock returns has been about twice the average returns. If we increase the volatility of your CD returns to plus or minus 10 percent, twice the average, your 10-year CD now pays only $1,556 at maturity, or $72 less.
What if a CD were available that magnified the volatility of returns to the degree a 3X stock market inverse ETF does (six times the average return)? At the end of 10 years, your CD would mature at only $1,064, generating a return of less than 1 percent annually.
On its first day of trading (July 13, 2006), the ProShares 2X inverse S&P 500 Index ETF (ticker symbol SDS) closed at $73.48 per share, while the S&P 500 Index itself stood at 1,242.28. As I write this, the S&P 500 stands at 1,293.24, representing a meager gain of 4.1 percent in four and a half years. Whither SDS? It closed at $22.47, having declined almost 70 percent.
The longer you hold ETFs designed to magnify the movement of an index, the worse the result. Mathematically, the negative effect of compounding volatile returns works the same way with positive ETFs as it does for inverse ones. The difference is that inverse ETFs at least appear to have a valid purpose of hedging your portfolio, or insuring against market downturns, although the numbers work against you. Positive 2X and 3X ETFs are nothing short of gambling.
Using inverse ETFs as a form of portfolio insurance may make sense for a short period of time. For example, you may need to draw on your investment account to cover the cost of a major purchase if a loan you’ve been seeking isn’t funded in a timely fashion. Over the period of one month, for example, and in the absence of severe market volatility, your purchase of a 2X inverse S&P 500 ETF with, say, 20 percent of your portfolio, could—at nominal expense—measurably soften the blow of a sudden market downdraft.
Other than for short-term insurance purposes, though, inverse ETFs, particularly those of the 2X and 3X variety, have no place in the portfolio of the savvy investor.
