Inverse exchange-traded fund - AbsoluteAstronomy.com

An inverse exchange-traded fund is an exchange-traded fund

Exchange-traded fund

An exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...

(ETF), traded on a public stock market

Stock market

A stock market or equity market is a public entity for the trading of company stock and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately.The size of the world stock market was estimated at about $36.6 trillion...

, 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

Derivative (finance)

A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...

such as futures contract

Futures contract

In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...

s, and other leveraged

Leverage (finance)

In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...

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

Individual Retirement Account

An individual retirement arrangement is the blanket term for a form of retirement plan that provides tax advantages for retirement savings in the United States...

, while short sales are not permitted in these accounts.

Strategies for buy-and-hold investors

There are a numbers of scenarios where a long-term investor could benefit from short or inverse ETFs. Investors trapped in a long position during a prolonged bear market might want to reduce their losses by using a short or inverse ETF. Another instance might be where a long-term investor has a large paper gain but doesn't want to pay taxes. Rather than watch a market decline eat away at the value of the investor's portfolio, selling short a market-tracking ETF, or purchasing an inverse or short ETF would help reduce losses.

Systemic impact

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 causes significant increases in volatility , while others that these are not significant (WSJ article cites dissent).

Fees

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 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

Market timing

Market timing is the strategy of making buy or sell decisions of financial assets by attempting to predict future market price movements. The prediction may be based on an outlook of market or economic conditions resulting from technical or fundamental analysis...

strategy.

Volatility loss

An inverse ETF as 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 though. 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.

As with synthetic options, leveraged ETFs needs to be frequently rebalanced. In financial mathematics terms, they are not Delta One products: they have Gamma.

The volatility loss is also sometimes referred to as a compounding error.

Hypothetical example

If one invests $100 in an inverse ETF position in an asset worth $100, and the asset's value changes to $80 and then 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.

Historical example

For instance, between the close of November 28, 2008 and December 5, 2008, the iShares Dow Jones US Financial 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 , which is a double-short ETF of the IYF moved from 135.05 to 117.18, a loss of 13.2%.

Expected loss

Given that the index follows a geometric Brownian motion

Geometric Brownian motion

A geometric Brownian motion is a continuous-time stochastic process in which the logarithm of the randomly varying quantity follows a Brownian motion, also called a Wiener process...

and that a fraction