With an absolute exposure of 100%, some people have started to look at single inverse ETFs as long term hedges for portfolios instead of the 200% and 300% inverse ETFs which most have deemed to be better as short term trading vehicles. The leveraged ETFs have been shown to suffer from a decay when holding for long periods of time, which we have seen occurs because of the daily rebalancing. In essence, to win with leveraged ETFs you not only have to be right in the underlying’s direction, but also on the path it takes getting there.
But what about the single inverse ETFs? They are not levered up and are designed to replicate -100% of the underlying’s daily performance. So are these tamer cousins worth considering for those seeking long term hedges? Are there any other potential uses for these ETFs?
Better for Retirement Accounts?
In retirement accounts which don’t allow short selling, you can now mimic the effect by buying a single inverse ETF. For example, let’s suppose you think the market might be poised to head down in the near term – you could purchase a single inverse ETF with part of your portfolio. But the problem is that this is expensive. For example, let us assume your portfolio is 100% invested in IVV (iShares S&P500 Index Fund). If you think the market is going down and you want to protect your portfolio, you could sell 50% of your IVV holdings and purchase SH (Single inverse S&P 500 Index ETF). But now your portfolio will get a zero rate of return as your profit/loss on one position is offset by the loss/profit on the other position… but you are still paying a small expense in the form of the ETF MERs (on both positions). If you wanted to eliminate your exposure to the market, you would be better off to sell the entire holding of IVV – there’s no management fee on cash. The same logic applies for partial hedging – you should consider just selling off a portion of your portfolio to reduce your exposure (and risk).
Better Than Holding A Short Position (In a short eligible account) When Hedging?
What about accounts that do allow short selling? These accounts are usually taxable accounts and you may have been holding IVV for a long time and may be sitting on a large unrealized capital gain. You think that long term, IVV will continue to rise but are worried about short term volatility, a sideways market, or even a temporary bear market. In this case, blindly selling off your portfolio will trigger the capital gains and a tax bill. You could short shares in IVV, which would hedge your portfolio’s risk – but that just seems odd: holding a long and short position in the same security? I’d prefer to to just own less, and take the balance and put it elsewhere, bonds, foreign index ETFs, etc.
To purchase a single inverse ETF (assuming no new contributions) would require you to sell part of your portfolio anyways. And when you think it’s time to release your hedge, you would have to sell off your single inverse ETF and then re-purchase your original long position. Seems like the trading costs will add up using this strategy, and you will still incur some taxable gains.
What About For Speculating?
Remember, hedging and speculating are completely opposite. Hedging is a reduction of risk. Speculation is the taking on of risk. Let’s pretend you don’t own any IVV, but you do think that the S&P 500 Index is heading south. You could speculate by shorting IVV or buying SH.
Shorting a security directly means your potential loss is theoretically unlimited as the underlying stock could keep going up. So in this case, buying SH (single inverse S&P 500 index ETF) limits your theoretical loss to your capital at risk – but in all seriousness, what are the chances of the S&P 500 going to zero?
Also, we have to pay interest on our short position (we have to borrow the shares to sell them short). The MER on SH (0.95%) is probably going to be less than the interest we pay to short IVV plus IVV’s MER (which is teeny-tiny at 0.09%.
Compounding/De-Compounding Risk Still There
So it seems that the single inverse ETFs may hold utility as very short term speculative plays. Since they seek to track the inverse of daily returns of the underlying indexes, we still have the risk of these not tracking like you might intuitively think they would.
Let’s say our index starts at 100, goes up 25% to 125 and then goes down 20% to 100. Our inverse ETF (let’s stay it too started at 100) goes down 25% to 75. It then goes up 20%, but this only brings it up to 90. So we still get our “decay” from volatility.
There is something interesting to point out though. A single inverse ETF will outperform a short position in either market direction in a slowly trending market. When a market is going down, your inverse ETF is compounding in your favour. When a market is going up, your inverse ETF is de-compounding in your favour. Introduce volatility, however, and this effect can be lost.
For example, let us say our index goes from 100 to 80 to 60. A short position of $100 would’ve ended up being worth $140. But a single inverse ETF went up 20% of 100 on day one (=120) and then up 25% of 120 on day two (=150) so you have $150 instead of $140 with the short. In the opposite direction, the index might go from 100 to 120 to 150. A short would have lost $50. The single inverse ETF would’ve lost 20% (down to 80) and then 25% (down to 60) for a total loss of $40.
Nasty Tax Surprises
Pro-Shares announced some large capital gains distributions on their short ETFs last year and if you happened to have picked up some of these ETFs, you could’ve been stuck with someone else’s tax bill. For example, SH’s short term capital gains distribution was $11.94 per share – that’s massive. You may want to avoid using these towards the end of December every year if you think the performance over the year might warrant similar distributions in the future. Another way to circumvent these problems would be to avoid overnight positions? More fodder for using these vehicles as extremely short term, speculative plays.
Perhaps Buying Puts Is A Better Alternative…
Given all the above information, I will stick to using these types of securities as strictly short term, speculative tools. In fact, given that purchasing put options provides more leverage, risk limited to capital invested in the puts, and possibly costs less (due to the leverage), I might be more inclined to consider these over the single inverse ETFs as a hedging tool.
Preet I had a thought, seeing as the industry is always willing to create tons of new products I wondered if they could create bear, bull or inverse ETFs that didn’t seek to track the daily return, like the current ones, but a longer term, say monthly or quarterly?
I don’t understand the underlying derivatives enough, but maybe you could play out the thought experiment to say if it’s possible?
Jordan,
I’ve wondered the same thing and asked about it. My understanding is the underlying derivative contracts just don’t make that economically feasible.
It would be good to get a template though of how you would actually manage a longer duration inverse ETF.
@Jordan – shooting from the hip, I would use an ETN instead – you would eliminate tracking error. I would include cost in the management fee to offset the interest on an underlying leveraged portfolio and include an insurance premium to cover the cost of tracking error – the premium would probably be up there, but I don’t think many people pay as much attention to fees when dealing with anything other than plain vanilla ETFs.
“there’s no management fee on cash. The same logic applies for partial hedging – you should consider just selling off a portion of your portfolio to reduce your exposure (and risk).”
It’s amazing that this is not crystal clear to everyone. I’ve heard of financial planners who encourage people to buy inverse funds, rather than simply sell a portion of their holdings. More fees for the planner.
“purchasing put options provides more leverage, risk limited to capital invested in the puts, and possibly costs less (due to the leverage), I might be more inclined to consider these over the single inverse ETFs as a hedging tool.”
They don’t cost less. Puts are expensive. You know I’m a huge fan of using options to hedge risk, but I suggest your readers consider the collar trade (buy puts, but also sell out of the money calls to offset the cost of the puts. This limits the upside, but it makes protecting your portfolio affordable – often free).
This should be republished when the markets start to fly again. Until then this could be wasteful as the market has already had a tidy haircut.
In the money puts might be the best. Higher cost up front, but less time value loss, of course less upside as it must overcome the real value. Of course one might need a volatile market for this?!
Selling puts on your favourite long term holds might be the best alternatives other than outright purchase.