Earlier this week I had a discussion with a colleague who, like many, is fearing a significant drop in the stock market and conversely, his retirement account. His concerns are not without reason: Every day in the financial press we see article after article about how overvalued equity markets are domestically and around the globe. Not only this, but the current September to November time frame historically tends to be very weak in terms of stock market performance.
This friend of mine off-the-cuff asked me if he should begin taking ‘short’ positions in stocks in the anticipation of protecting his portfolio and even making some profits along the way when his prediction of an impending stock market decline materializes. Specifically he mentioned what are called ‘Inverse ETFs’ (exchange traded funds) in his inquiry and whether he should begin building a position in these products.
What are inverse ETFs? Inverse ETFs are essentially a bundled investment that attempts to do just what their name implies: provide a return that is equal in magnitude, but opposite in direction, on a particular stock market index or benchmark that they are trying to replicate. For example, investing in the ProShares Short S&P 500 ETF (ticker symbol: SH) will provide investors with a return equal to the opposite return of the S&P 500 index. Inverse ETF products are abundant and offered on a wide variety of market indexes and benchmarks. For example, one can gain short exposure to a particular country like China (ex. the Direxion Daily CSI 300 China A Fund), a sector like energy (ex. the ProShares Short Oil and Gas Fund) or even volatility (ex. the ProShares Short VIX Short-Term Futures Fund).
Respectfully I responded to my colleague with the comparison of inverse ETFs to a long weekend in Las Vegas at the black jack table, or worse yet, playing the one-armed bandits as slot machines are affectionately referred to. Just like gambling at the casino, the longer you stay invested in inverse ETFs, the greater your chance of losing money, which can turn into a lot of money if you’re not careful and let the position get away from you. In essence, due to the variety of risks involved in these funds, it is inevitable that the majority of investors WILL lose money.
Why are inverse ETFs so risky? The problem with these products is that come with a variety of unique risks that immediately put an investor at a distinct disadvantage right from the start. In fact, if one takes a look at the prospectus of an even fairly plain-vanilla inverse ETF, the ProShares Short S&P 500 (ticker symbol: SH), in bold writing, bottom right hand corner of page 4, under “Principal Risks”: You may lose the full principal value of your investment within a single day. Right away this should raise a red flag, at a minimum.
How many risks are involved with inverse ETFs? Our relatively straightforward inverse ETF like the ProShares Short S&P 500 ETF comes with 22 risk. 22! Many of these risk are fairly complicated and beyond the scope of not only the majority of investors, but also this article. Just for interest’s sake, a few risk that are particular to inverse ETFs are: risks associated with derivatives, leverage risk, compounding risk, correlation risk, rebalancing risk, counterparty risk, short sale exposure risk and inverse correlation risk.
Now getting back to my colleague who was inquiring about buying inverse ETFs to protect his portfolio in a stock market downturn: He’s thinking that as long as you hold an inverse ETF for whatever period of time, you will receive the exact opposite return of the index that it is intended to replicate, right? Wrong. Dead wrong.
The reason why inverse ETFs do not return the exact opposite amount that they intend to (especially over longer time periods) is because ETF products are designed to match the benchmark’s opposite return on a daily basis. It is plain and clear in their prospectuses that their objective is to “seeks daily investment results, before fees and expenses, that correspond to the inverse (-1x) of the return of the S&P 500® Index (the “Index”) for a single day, not for any other period”. Key phrase “single day”. Not for any period longer.
This is where the risk mentioned earlier, “compounding” risk comes into play. If you buy an inverse ETF and its benchmark does decline for several straight days, you might get lucky and get fairly close to matching the opposite return to the benchmark over this short time period. In our casino example, you could compare this to being at the blackjack table and winning 5 consecutive hands.
However, with daily compounding risk, an investor can experience substantial losses if the benchmark experiences moves against them for several days. Worse yet, the benchmark doesn’t even have to move against them severely to experience substantial losses. Instead, if the fund’s comparative benchmark experiences increased volatility and the index gyrates wildly from day-to-day, losses can easily exceed losses from its benchmark. It is in these cases where an investor is at this ‘mathematical disadvantage’ because it takes a larger percentage gain to recoup losses.
The compounding risk coupled with high volatility is clearly identified in the SH fund prospectus, page 5, where the chart shows the magnitude of losses when stock market volatility is high. For example, over 1-year period, if the S&P 500 goes up 20%, one would expect the SH inverse ETF to return -20%. However, even without expense fees, the return would be closer to -35.1% with 25% volatility. Not exactly the -20% a truly ‘inverse’ inverse product would indicate. Again, in our casino example, the longer you hang around the blackjack table and play, the better chance you have of losing.
A second risk that can leave investors with losses in these products are the type of investments they employ. These riskier investments are called ‘derivatives’ and can take a variety of forms. Futures contracts that need to be bought and sold to provide negative correlation may provide a different return than the index itself (particularly if the futures contracts are in a substantial contango or backwardation position when the fund needs to rebalance). Inverse funds can also use what are called SWAP positions where a return is ‘traded’ with a counterparty that may not be able to fulfil its obligation in the contract (called credit risk).
A third important risk with inverse ETFs is the much higher management fee they come with, which alone puts an investor at a distinct disadvantage regardless of how the fund performs. The SH inverse fund for example has a management expense fee of 0.90% vs 0.03% for the Vanguard S&P 500 ETF (ticker: V00). The fund’s management expense pays for such things as the fund manager’s salary, custodial and trading costs and marketing materials.
To make matters worse (if that’s even possible) with inverse ETFs is that the fund companies offering them have devised inverse ETFs that offer 2X or even 3X the inverse exposure to an index. In the example above, this not only would magnify the losses an investor would face if the positon moved against them, but even more substantial losses could occur if the volatility of the underlying benchmark they are trying to replicate increases substantially.
Given that the long-term direction of the stock market is up, inverse ETF products can be a risky endeavor for most investors. Unless you have lots of time to sit behind your computer and day trade these products, I would steer very clear of owning any inverse ETFs in my portfolio.