Inverse exchange-traded funds (ETFs) seek to deliver inverse returns of underlying indexes. To achieve their investment results, inverse ETFs generally use derivative securities, such as swap agreements, forwards, futures contracts and options. Inverse ETFs are designed for speculative traders and investors seeking tactical day trades against their respective underlying indexes.

Inverse ETFs only seek investment results that are the inverse of their benchmarks' performances for one day only. For example, assume an inverse ETF seeks to track the inverse performance of Standard & Poor's 500 Index. Therefore, if the S&P 500 Index increases by 1%, the ETF should theoretically decrease by 1%, and the opposite is true.

Important

Inverse ETFs carry many risks and are not suitable for risk-averse investors. This type of ETF is best suited for sophisticated, highly risk-tolerant investors who are comfortable with taking on the risks inherent to inverse ETFs.

Key Takeaways

  • Inverse ETFs allow investors to profit from a falling market without having to short any securities.
  • Because of how they are constructed, inverse ETFs carry unique risks that investors should be aware of before participating in them.
  • The principal risks associated with investing in inverse ETFs include compounding risk, derivative securities risk, correlation risk and short sale exposure risk.

Compounding Risk

Compounding risk is one of the main types of risks affecting inverse ETFs. Inverse ETFs held for periods longer than one day are affected by compounding returns. Since an inverse ETF has a single-day investment objective of providing investment results that are one times the inverse of its underlying index, the fund's performance likely differs from its investment objective for periods greater than one day. Investors who wish to hold inverse ETFs for periods exceeding one day must actively manage and rebalance their positions to mitigate compounding risk.

For example, the ProShares Short S&P 500 (NYSEARCA: SH) is an inverse ETF that seeks to provide daily investment results, before fees and expenses, corresponding to the inverse, or -1X, of the daily performance of the S&P 500 Index. The effects of compounding returns cause SH's returns to differ from -1X those of the S&P 500 Index.

As of June 30, 2015, based on trailing 12-month data, SH had a net asset value (NAV) total return of -8.75%, while the S&P 500 Index had a return of 7.42%. Additionally, since the fund's inception on June 19, 2006, SH has had a NAV total return of -10.24%, while the S&P 500 Index has had a return of 8.07% over the same period.

The effect of compounding returns becomes more conspicuous during periods of high market turbulence. During periods of high volatility, the effects of compounding returns cause an inverse ETF's investment results for periods longer than one single day to substantially vary from one times the inverse of the underlying index's return.

For example, hypothetically assume the S&P 500 Index is at 1,950 and a speculative investor purchases SH at $20. The index closes 1% higher at 1,969.50 and SH closes at $19.80. However, the following day, the index closes down 3%, at 1,910.42. Consequently, SH closes 3% higher, at $20.81. On the third day, the S&P 500 Index falls by 5% to 1,814.90 and SH rises by 5% to $21.85. Due to this high volatility, the compounding effects are evident. Due to rounding, the index decreased by approximately 7%. However, the effects of compounding caused SH to increase by a total of approximately 10.25%.

Derivative Securities Risk

Many inverse ETFs provide exposure by employing derivatives. Derivative securities are considered aggressive investments and expose inverse ETFs to more risks, such as correlation risk, credit risk and liquidity risk. Swaps are contracts in which one party exchanges cash flows of a predetermined financial instrument for cash flows of a counterparty's financial instrument for a specified period.

Swaps on indexes and ETFs are designed to track the performances of their underlying indexes or securities. The performance of an ETF may not perfectly track the inverse performance of the index due to expense ratios and other factors, such as negative effects of rolling futures contracts. Therefore, inverse ETFs that use swaps on ETFs usually carry greater correlation risk and may not achieve high degrees of correlation with their underlying indexes compared to funds that only employ index swaps.

Additionally, inverse ETFs using swap agreements are subject to credit risk. A counterparty may be unwilling or unable to meet its obligations and, therefore, the value of swap agreements with the counterparty may decline by a substantial amount. Derivative securities tend to carry liquidity risk, and inverse funds holding derivative securities may not be able to buy or sell their holdings in a timely manner, or they may not be able to sell their holdings at a reasonable price.

Correlation Risk

Inverse ETFs are also subject to correlation risk, which may be caused by many factors, such as high fees, transaction costs, expenses, illiquidity and investing methodologies. Although inverse ETFs seek to provide a high degree of negative correlation to their underlying indexes, these ETFs usually rebalance their portfolios daily, which leads to higher expenses and transaction costs incurred when adjusting the portfolio. Moreover, reconstitution and index rebalancing events may cause inverse funds to be underexposed or overexposed to their benchmarks. These factors may decrease the inverse correlation between an inverse ETF and its underlying index on or around the day of these events.

Futures contracts are exchange-traded derivatives that have a predetermined delivery date of a specified quantity of a certain underlying security, or they may settle for cash on a predetermined date. With respect to inverse ETFs using futures contracts, during times of backwardation, funds roll their positions into less expensive, further-dated futures contracts. Conversely, in contango markets, funds roll their positions into more-expensive, further-dated futures. Due to the effects of negative and positive roll yields, it is unlikely for inverse ETFs invested in futures contracts to maintain perfectly negative correlations to their underlying indexes on a daily basis.

Short Sale Exposure Risk

Inverse ETFs may seek short exposure through the use of derivative securities, such as swaps and futures contracts, which may cause these funds to be exposed to risks associated with short selling securities. An increase in the overall level of volatility and a decrease in the level of liquidity of the underlying securities of short positions are the two major risks of short selling derivative securities. These risks may lower short-selling funds' returns, resulting in a loss.