Another risk: While it may be difficult to remember in light of recent turmoil, markets tend to go up over the long term. Although these ETFs have a short history, the longer track records of bear market mutual funds show that they can have prolonged periods of negative returns. When the market revives this time around, the losses on these funds could be dramatic, especially for the leveraged versions that double or triple inverse returns.
Intraday pricing anomalies and tracking error present another problem. To produce inverse returns, the funds depend on a mix of derivative instruments: futures; options on futures contracts; forward agreements; and swaps. The prices on these move so quickly it can be difficult for the ETFs to track an index precisely.
In a recent article in IndexUniverse.com, Anthony Welch, a portfolio manager at Sarasota Capital Strategies in Osprey, Fla., notes that on one trading day in November an ultra-short S&P 500 index ETF rose 6.6% at a time when the index was down 3%, creating a tracking error of 60 basis points. As the sell-off gained steam later in the day, the tracking error rose to 80 basis points. "Toward the end of such active days, leveraged and inverse ETFs tend to gravitate back toward fair value. But they don't always," he observes.
Morningstar analyst Bradley Kay points out that the derivatives used by the ETFs to produce their daily returns are always taxed at short-term capital gains rates. Because investors are taxed on a look-through basis, he notes, investors pay taxes based on what they would have to pay if they had held the underlying securities directly. An investor who sells such funds at a gain will face a hefty tax bite equal to the short-term capital gains rate, even if the fund was held for more than a year.
Controlling Volatility
Despite these issues, financial advisors who have used inverse ETFs say they can be an effective hedging tool and a way for investors to protect long positions and lower portfolio volatility. "If a portfolio is too volatile, short ETFs can decrease the beta and balance the portfolio against a downturn without selling existing holdings and recognizing the associated tax consequences," says Simon Maierhofer, an investment advisor and co-founder of ETFguide.
As a safeguard, Maierhofer uses what he calls "dollar-cost averaging hedging." In this approach, the investor sets a goal and gradually decreases exposure as it gets closer. For example, if the Dow is at 8,500 and someone expects it to fall below 7,500, he would buy a short ETF at the higher level, sell one-third of the position when the Dow reaches 8,000, another third when it reaches 7,800, and the final third when it drops to 7,500.
Welch, who uses inverse ETFs for most of his clients, says the strategy has narrowed losses dramatically. One of his models calls for taking long positions in sectors showing the strongest relative strength measures according to his analysis and pairing them with a certain percentage of inverse ETFs that use the S&P 500 index as a benchmark. To implement it, he uses equal-weighted sector ETFs from Rydex on the long side and pairs them with inverse ETFs as a hedge.
Jim Holtzman, principal at Legend Financial Advisors in Pittsburgh, says his firm began using short and leveraged short ETFs during the summer of 2008 in its more aggressive portfolios. The leveraged versions providing double exposure, he says, are particularly useful when the client may not have enough assets available for an effective hedge. "Taking a 2% position in an ultra-short ETF is the same as having a 4% short exposure. You just have to keep an eye on things and pare back when you need to because they can move very quickly," he says. The typical holding period is in the two-month range, although that can vary widely depending on market volatility.
Holtzman says his firm has used short ETFs that provide exposure to emerging markets, the S&P 500 index and the Russell 2000 Index, and that they often take the place of short selling or moving more money into cash. "They've really made a difference in terms of stabilizing our portfolios," he says. "There have been some terrible down days for the market where we've been able to come out fairly well."
Even if low stock market valuations lure bargain hunters and turn the market tide, inverse ETFs might prove useful on a more limited basis as well in an up market. Investors could use them to implement a relative value strategy, which involves pairing up investments with different outlooks. For example, someone who is bullish on large-cap stocks and bearish on small caps could create a hedge by investing long in the former and using a small-cap index inverse ETF for the latter. The funds can also be used to hedge large positions in individual stocks. But even those people who have successfully invested in inverse ETFs in the past emphasize that these funds must be handled with care. "Short ETFs, as alcohol, should be used in moderation," says Maierhofer. "The right amount will result in a nice time, but if you overdose, you might wake up with a hangover."