Looking at investment scorecards for 2008, it is clear that betting against the market was one of the few ways to salvage positive returns from an otherwise dismal year. Among the biggest winners were inverse and leveraged inverse ETFs, some of which posted high double-digit and even triple-digit returns for the year.
Inverse or short ETFs are designed to do the opposite of what the market does. If a particular index rises 10%, an inverse ETF based on that index is supposed to fall in value by a similar amount, less fees and expenses. If the index rises, the value of the ETF will fall proportionally. Dozens of new inverse and leveraged inverse ETFs have been introduced in the last year for a wide range of market indexes covering broad markets, sectors, commodities and even fixed-income. Of the ten most heavily traded ETFs in November, three were ultra-short products, reflecting growing interest among all types of investors including hedge funds.
The price movements of these leveraged versions are approximately double, and in some cases triple, the inverse of their benchmark indices. ProShares introduced short and ultra-short ETFs in 2006, and it currently has 44 of them on the market with $13 billion in assets, over twice the level at the beginning of 2008. Some $12 billion of that is in the ultra-short, double-inverse products. "It appears that people want to get more bang for the buck," observes ProShares CEO Michael Sapir.
Here's a simple example of how an ultra-short ETF might work as a hedge: Suppose a long ETF position appreciated from $10,000 to $20,000. A decline of 20% in the ETF benchmark index would mean a paper loss of about $4,000. To help protect against that possibility, an investor could buy $5,000 of an ultra-short ETF corresponding to the long investment. A 20% decline in the index would raise the value of the ultra-short, double inverse investment by approximately 40%, or $2,000, shrinking the total loss on the combined long-short position by half. If the market went up, on the other hand, the inverse ETF would have a negative impact on portfolio performance.
Inverse ETFs provide a well-paved entry point for investors looking to profit from a market decline or reduce portfolio losses in a bear market. They are easier to put in place than short sales, which require an investor to open a margin account and borrow from a broker, and they require less expertise than some other bear market strategies involving futures and options. They have also become more attractive after an SEC rule introduced in September required short sellers to borrow company shares before selling them, rather than engage in a naked short sale.
But inverse ETFs can also add fuel to already rampant market volatility. Leveraged inverse sector ETFs, such as those covering financials or real estate, can gain or lose as much as 30% in a couple of days. Four triple-inverse ETFs introduced by Direxion Shares in November stoke the fire more, ramping up volatility with an increased use of leverage, while the unleveraged versions covering the broader markets have the tamest profile of the group and are about as volatile as their respective benchmarks.
Because of wild price swings, investors must watch their positions in these products and adjust them frequently to ensure the ETF matches the desired hedging strategy. If the market is down substantially over a few days and the value of the inverse ETF has increased, for example, an investor would need to pare the bear holding to better match the long position and preserve the original hedge. Conversely, if the inverse ETF declined substantially in value after a bear market bounce, it would be necessary to beef up the position.
Some experts believe that advisors who don't want nasty surprises from inverse ETFs and want to use them should buy and sell these vehicles every day. In period of extreme volatility like the last five months, they also advocate using limit orders.
"Most financial advisors who use inverse ETFs monitor their portfolios at least a few times a week and often daily," says Daniel O'Neill, president of Direxion Shares. "These aren't for the typical buy-and-hold investor." Still, since their introduction in November, the firm's 3x leveraged ETFs have gathered $750 million in assets, with about half on the inverse side.
Jerry Slusiewicz, president of Pacific Financial Planners in Newport Beach, Calif., says he constantly watches his triple inverse ETF positions because they are so volatile. While stop-loss orders can be useful in most markets, he says, intraday volatility makes them less effective. "If you have an ETF that swings 20% in one day and there is a 10% stop-loss on it, you can get whipsawed out of the position before it bounces back," he cautions.