RSS feedI mentioned yesterday that inverse ETFs could be used in place of straight shorting for those that do not have access to margin accounts and, subsequently, the ability to short. After doing some more research on inverse ETFs, I realized that I should not have said that they give you exactly the same exposure. Shorting an ETF would give you exactly the opposite performance that the ETF has over a period of time. Shorting anything does that actually. Basically, the idea is you borrow shares at a given price and sell them thus pocketing the money from that sale. Eventually, you have to buy back the shares (cover) to return to whoever you borrowed it from. In the end, the person you borrowed the shares from has their shares back and whatever difference in price is yours. As such, you hope that you can buy back the shares that you shorted at a lower price.
An inverse ETF works a little bit differently than a straight short. And, this answers the question of why an inverse ETF will not typically go to zero, unless something absolutely unprecedented like a 50% or 100% appreciation in the underlying index happens. If you read an inverse ETF’s investment goal carefully it mentions that it hopes to replicate -100% or -200% of an underlying index’s daily percentage gain. This matters because over a period of time, this will mean that you won’t get exactly the performance of a short.
For example, if the underlying index is trading at $1000 and appreciates to $1200 and then to $1440. This represents two days of 20% gains. An inverse ETF would thus lose 20% each day. If you had $100 invested, assuming perfect tracking, your portfolio would be worth 80 and then 64. In the end, the first portfolio has a 44% gain, but your portfolio only has a 36% loss. This also works in reverse. If the index falls 20% two days in a row starting at $1000, you have 800 and then 640 representing a 36% loss. Your investment will gain 20% each day and thus return 44%. Does this mean that an inverse ETF will always magnify your gains and limit your losses when you’d like to be short? Not at all. If there are a mix of up and down days, your expected returns change a lot. For example, in a simple two day period, if an index is up 10% each day for a 21% gain over two days, the inverse ETF will lose 10% each day for a lost of 19%. In the same two day period, if the index is up 21% and then
All-in-all, using inverse ETFs as part of a paired trading/market neutral technique is not an optimal choice. They still work to hedge and pairing them will likely work to hedge some risk, but they aren’t the win-win I painted them to be yesterday. For those without the ability to short, inverse ETFs will likely work as you will be getting exposure similar to what you expect from a short, but it won’t be exact and as a result is less predictable.
