The Financial Industry Regulatory Authority (FINRA) recently notified brokers who sell complex Exchange-Traded Funds (ETFs) that “inverse and leveraged ETFs typically are not suitable for retail investors who plan to hold them for more than one trading session.” The warning is long overdue, as leveraged ETFs were first introduced in 2006 after three years of SEC review.
FINRA’s warning about the dangers of leveraged and inverse ETFs is extremely important. I’ve been surprised to see leveraged and inverse ETFs recommended in a number of retail consumer-oriented publications. It’s very dangerous for investors to jump into these products when they don’t understand them and the risks involved with them.
What’s wrong with leveraged or inverse ETFs? Nothing, if you know how to use them. The problem is that they’re complicated instruments and most people don’t understand how they work. I’ll try to explain them, beginning in this post with inverse ETFs.
Why Would You Want an Inverse ETF, Anyway?
Historically, the way to invest if you believed that a security (or index) was going to decline in value was to sell it short – sometimes just called “shorting.” Shorting involves borrowing a security from someone else (paying them interest until you return it) via a broker and selling those shares to someone else. If the price drops as expected, you buy the shares back at a lower price and return them to the lender. If you paid a lower price than the price for which you sold the shares, you made a profit after the cost of borrowing. Shorting has certain disadvantages:
The shares you want may be in short supply, making them hard to short.
The broker may demand the return of the shares at any time, so you could be forced to close the position before you’ve made a profit.
The price of the security may shoot up instead of going down, forcing you to buy shares back at a much higher price. Potential losses are theoretically unlimited in a short sale because there is no upper limit to the price of a stock.
Retirement accounts cannot hold short positions, so a sophisticated investor with a legitimate reason to sell short cannot do so in such an account.
Inverse ETFs address these shortcomings, while (as we’ll see) creating some new ones. ETF losses are limited to 100%, and ETFs can be held in retirement brokerage accounts.
How Inverse Exchange-Traded Funds Work
Many “vanilla” ETFs are passive instruments that are intended to closely track the movement of a basket of securities. Inverse ETFs provide a twist on this approach; instead of tracking what an index does, an inverse ETF’s price is supposed to move in the direction opposite to the daily movement of its index. For example, an inverse ETF for the S&P500, if it worked perfectly, would move down 5% when the S&P500 moves up 5%. You’ll notice that I said, “if it worked perfectly.” In practice, these products can’t deliver the opposite return perfectly for several reasons. The most obvious reason is fund expenses: you must pay to trade an ETF, and ETF managers charge annual expenses that can range from about 0.09% to 1.25%, depending on the underlying securities.
Inverse ETFs accomplish their inverse behavior using contracts (“securities derivatives”) called swaps and/or futures. In an inverse ETF swap contract, the ETF pays a counterparty a fee; in return, the counterparty promises to make payments back to the ETF based on whether and how much the ETF’s index or basket of securities declines in value on a given day. If the index increases in value, the ETF pays the counterparty.
It’s important that I pause here to emphasize a point – note that I said that these agreements are based on market activity on a daily basis. The significance of this point will become clear in a minute.
Why would a counterparty enter into such an agreement? It either has a need to “hedge” an existing position which loses money when the index goes up in value, or else it simply wishes to make a speculative investment. Swap contracts carry “counterparty risk:” the other party may fail to hold up its end of the contract if it becomes insolvent. Instead of a swap, an ETF might use futures contracts or other derivative securities that settle on a daily basis. These contracts also involve a promise of payment based on the closing price of the index. With a futures contract, the counterparty is a clearing corporation that can normally ensure that the parties to each contract are able to fulfill the contract terms. In practice, inverse ETFs tend to use swaps much more heavily than futures, so counterparty risk is always an issue. This is another important risk of inverse ETFs, usually disclosed somewhere deep in its prospectus.
Because inverse ETFs must purchase and sell derivative contracts every day, they’re not able to pick and choose which positions to sell and cannot minimize the capital gains impact of their transactions; thus, they often lack the tax-efficiency generally associated with exchange-traded funds. Even for sophisticated traders who understand their risks and subtleties, inverse ETFs do not always perform as expected. A recent paper by Frank Elston and Doug Choi indicates that in 2008, investors would often have been better off “shorting” securities and avoiding inverse ETFs.
The Problem With Inverse ETFs For Long-Term Investors
The big problem with inverse ETFs for most retail investors was highlighted earlier: they’re designed to replicate the behavior of an index on a daily basis. If an ETF does this successfully, it can be useful for someone who trades daily, but those with longer time frames in mind may find their results disappointing.
Consider a simple example in which you buy an imaginary ETF that works perfectly, with zero transaction costs or internal expenses. The ETF moves inversely to a stock index. Over the course of a week, the index moves daily as follows:
|Day 1||900 (Down 10%)|
|Day 2||990 (Up 10%)|
|Day 3||891 (Down 10%)|
|Day 4||998 (Up 12%)|
|Day 5||899.9 (Down 9.82%)|
The index ended the week down a total of 10.01%. Most investors would assume that at the end of the week, their ETF position would be up 10%. In fact, their investment would only be up a bit more than 5% for the week:
|Day 1||1100 (Up 10%)|
|Day 2||990 (Down 10%)|
|Day 3||1098 (Up 10%)|
|Day 4||958.3 (Down 12%)|
|Day 5||1052.4 (Up 9.82%)|
In fact, notice that after Day 2, both the index AND the ETF have lost 1%! Even with a hypothetical “expense-free” ETF, compounding effects can eliminate any direct connection between the long-term (longer than one day) performance of the ETF and that of its index.