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Exchange-Traded Funds, commonly known as ETFs, hold an underlying basket of securities that investors can purchase and sell without having to own each of the underlying assets.
Many ETFs are designed to serve as lower risk, long-term, passive investments. However, there are a few special types of ETFs that do not fit this mold. One of these exceptions is the inverse and inverse Leveraged ETF, an investment vehicle with higher inherent investment risk due to the price volatility caused by the leverage utilized by the ETF. Leveraged ETFs are securities designed to be monitored daily and held for limited periods of time.
What are inverse ETFs?
Chapter 2 – Understanding Leveraged and Inverse ETF from Direxion on Vimeo.
While many ETFs track the results of an index, inverse ETFs track the opposite results of an index.
Inverse ETFs can be used to bet against the market. For example, if an investor thinks that the market is going to decline, he or she can purchase an inverse ETF to benefit from the dip, or to hedge against potential losses in the rest of his or her portfolio.
For example, lets say you invest $100 in an S&P 500 Inverse ETF. If the S&P is up 1% at the end of the day, youll now have ~$99. If the S&P is down 1% at the end of the day, youll now have ~$101. . Investments held for a period longer than one day will be affected by compounding and may have an effective investment multiple which is more or less than the daily multiple of the ETF. More about compounding below.
Why is it potentially risky to hold an inverse ETF for more than a day?
Chapter 3 – Daily Rebalancing from Direxion on Vimeo.
Inverse ETFs allow sophisticated investors to bet on extremely short-term shifts in the market. Most ETFs buy and sell securities in their basket to reflect the index they track quarterly, a practice called rebalancing. However, inverse ETFs also have a daily rebalance. The daily rebalance is designed to reset the exposure of the ETF to align with the ETFs investment mandate. For example, if you purchased a 3X Bear ETF, and at the end of the trading day the ETF has decreased in value, then the portfolio management must purchase additional exposure to rebalance the leveraged multiple of the portfolio prior to the next trading day.
Because of the inverse multiplier on the return and the daily rebalancing, holding them for any longer than a day exposes your portfolio to investment leverage which may be more or less than the daily leverage of the ETF which could lead to higher daily investment gains or losses. This is called compounding risk.
Lets compare what would happen if you invested $100 in an S&P 500 ETF and an Inverse S&P 500 ETF in different market conditions.
Rising Market:
| Day | S&P 500 Price | S&P 500 Return | Inverse S&P 500 Return | S&P ETF Investment | Inverse S&P ETF Investment |
| 0 | 5,000.00 | – | – | $100.00 | $100.00 |
| 1 | 5,050.00 | 1.00% | -1.00% | $101.00 | $99.00 |
| 2 | 5,151.00 | 2.00% | -2.00% | $103.02 | $97.02 |
| 3 | 5,202.51 | 1.00% | -1.00% | $104.05 | $96.05 |
| 4 | 5,358.59 | 3.00% | -3.00% | $107.17 | $93.17 |
| 5 | 5,492.55 | 2.50% | -2.50% | $109.85 | $90.84 |
| Total Return | 492.55 | 9.85% | -9.16% | $9.85 | -$9.16 |
Over the course of 5 days, the inverse investment lost less than 1x the return of the non-inverse investment.
Falling Market:
| Day | S&P 500 Price | S&P 500 Return | Inverse S&P 500 Return | S&P ETF Investment | Inverse S&P ETF Investment |
| 0 | 5,000.00 | – | – | $100.00 | $100.00 |
| 1 | 4,950.00 | -1.00% | 1.00% | $99.00 | $101.00 |
| 2 | 4,851.00 | -2.00% | 2.00% | $97.02 | $103.02 |
| 3 | 4,802.49 | -1.00% | 1.00% | $96.05 | $104.05 |
| 4 | 4,658.42 | -3.00% | 3.00% | $93.17 | $107.17 |
| 5 | 4,541.95 | -2.50% | 2.50% | $90.84 | $109.85 |
| Total Return | -458.05 | -9.16% | 9.85% | -$9.16 | $9.85 |
Over the course of 5 days, the inverse investment gained more than 1x the return of the non-inverse investment.
Voltatile Market:
| Day | S&P 500 Price | S&P 500 Return | Inverse S&P 500 Return | S&P ETF Investment | Inverse S&P ETF Investment |
| 0 | 5,000.00 | – | – | $100.00 | $100.00 |
| 1 | 5,500.00 | 10.00% | -10.00% | $110.00 | $90.00 |
| 2 | 5,000.00 | -9.09% | 9.09% | $100.00 | $98.18 |
| 3 | 4,500.00 | -10.00% | 10.00% | $90.00 | $108.00 |
| 4 | 4,750.00 | 5.56% | -5.56% | $95.00 | $102.00 |
| 5 | 5,000.00 | 5.26% | -5.26% | $100.00 | $96.63 |
| Total Return | 0.00 | 0.00% | -3.37% | $0.00 | -$3.37 |
Over the course of 5 days, the non-inverse investment remained flat while the inverse investment lost 3.37%.
How do investors determine the role of inverse ETFs in their strategies?
Inverse ETFs come with the potential for outsized gainsor lossesand require a more hands-on, short-term approach that may diverge from a typical long-term investing strategy. Sophisticated investors will sometimes combine long- and short-term approaches; however, its important to understand the full context before trading higher-risk products.
Ask yourself the following questions:
- Are you a sophisticated, experienced investor?
- Do you understand how leveraged ETFs work, and how compound risk could impact performance?
- Do you understand and accept the potential to lose substantial amounts in short periods of time?
- Are you able to actively monitor and manage your leveraged ETF investments throughout the day by buying and selling shares?
If you can answer yes to all of the questions above, trading inverse ETFs may be suitable for you.