Inverse ETFs were created as an alternative to shorting, which profits from falling prices.
But if you use these exchange traded funds, don't necessarily expect to get the same results as if you shorted the indexes yourself.
The largest inverse and leveraged ETF provider, ProShares, warns it doesn't guarantee the funds will actually do what they're supposed to, and their prices will not equal the opposite or double the opposite of their underlying benchmark over longer periods of time.
That's because of mathematical compounding and market volatility. Record volatility during the 2008 bear market also increased tracking error. The more thinly traded an ETF, the more likely it will have tracking error.
Inverse ETFs synthetically create the negative return of the underlying ETF by using complex financial instruments such as swaps, futures and options. They don't actually borrow shares with the hopes of returning them later at a lower price.
ProShares Short S&P 500 (SH), which trades 1.37 million shares a day on average, gained 37% in 2008, while its opposite, the SPDR (SPY), sank 38%, nearly the opposite of the former.
But the more volatile ProShares Short QQQ (PSQ), which trades on average 395,000 shares a day, climbed 37% in 2008, while its long brethren, PowerShares QQQ (QQQQ), fell 43%.
The difference is staggering with ProShares Short MSCI Emerging Markets (EUM), which returned 8% in 2008. The long version, iShares MSCI Emerging Markets (EEM), tanked 54%.
Supersized Exposure
Double- and triple-leveraged, long and inverse ETFs amplify your returns and losses by 200% and 300% on a daily basis. Every index lost value in 2008 but so did many of leveraged inverse ETFs, which were designed to move the opposite direction.
iShares FTSE/Xinhua 25 (FXI) lost 49% in 2008. Investors who bought the leveraged, short version, ProShares Ultrashort FTSE/Xinhua (FXP) may have expected a 98% return. Instead, FXP tumbled 54%.
ProShares UltraShort Real Estate (SRS), ProShares UltraShort Oil & Gas (DUG), ProShares UltraShort Emerging Markets (EEV) also closed 2008 in the red, down 54%, 16% and 28%, respectively, even though their underlying indexes all lost value.
Leveraged long ETFs, ProShares Ultra Real Estate (URE) and ProShares Ultra Oil & Gas (DIG) also lost money.
How can that be? Daily compounding.
Say you put $100 in each of three funds: XYZ index, XYZ double-long and XYZ double-short. On day one, XYZ gains 10% and closes at $110. The double-long would rise 20% to $120. The double-short would fall 20%, ending at $80.
The next day, say XYZ loses 10%. It would close at $99 because 10% of $110 is $11 (110 - 11 = 99). The double long fund would lose 20%, or $24, ending at $96 (120 - (120 x 0.20) = 96). The double-short, which started the day at $80, would grow to $96 (80 + (80 x 0.20) = 96).
After two days, the index has lost 1%, while the double-short fund has fallen 4%.
The effect could only get worse with the triple-leveraged Direxion ETFs, released in November 2008.
ETF experts recommend only using leveraged and inverse funds as a short-term hedge, not to double down, and only if you're an experienced investor who can monitor your positions like a hawk.
