This is the second part of our two part series. Last time we discussed leveraged Exchange Traded Funds (ETFs). In this post, we are going to discuss a related kind of ETF: Inverse ETFs.
An Inverse ETF offers investors a daily return that is opposite of the daily return of the index or asset tracked by the ETF. For example, an inverse ETF that tracks the S&P 500 index (SPX) would return the inverse of the daily return of the SPX. So if SPX exhibited a return (loss) of 10%, then an investor in the fund would see a loss (return) of 10%. Since their introduction in 2006, the number of inverse ETFs has grown quickly over the past five years.
Number of (US Domiciled) Inverse ETFs from 2006 to 2011
Inverse ETFs must rebalance on a daily basis since at any time an investor could buy the fund and at that point the ETF needs to be of the appropriate leverage. The effects of rebalancing on buy-and-hold investors compound over time and lead to substantial deviations from expectations. We present the following table as an example of the compounding effect of rebalancing.
Hypothetical Scenario to Illustrate Effect of RebalancingNotice that the underlying asset has (basically) not changed at all in price; however, the net equity value in the inverse ETF experienced a 18% decrease. The take-away message from this is that buy-and-hold investors should not invest in inverse ETFs unless they understand the risks associated with daily rebalancing.
Although we have only discussed in detail -1x (Inverse) ETFs here, there are also many inverse leveraged ETFs on the market that offer investors multiples of the inverse daily returns of an underlying index or asset.
Proshares discusses the rebalancing issue in some detail here and here. For further reading on this topic, we suggest taking a look at our paper on the effect of rebalancing on investors in ETFs.
SOURCE: Bloomberg L.P.