Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

Are Inverse ETFs Always Bad?

By

They have been blamed for a sizable amount of "user error" losses in recent months, but when is the best time to deploy inverse ETFs?

PrintPRINT

Sometimes, what you don't know can kill you-even in the relatively controlled world of ETF investing.

For example, my firm's Cabot ETF Investing System runs two strategies. The Long-Only strategy alternates between owning ETFs of favored S&P (INDEXSP:.INX) sectors (in uptrends) and holding cash (in downtrends). The Long-Short strategy-for more aggressive portfolios-holds those same favored sectors in uptrends, but sells short the S&P tracking ETF, S&P 500 SPDR (NYSEARCA:SPY), in downtrends.

But some investors-generally those with retirement accounts-are not allowed to sell short. So they ask whether they can use an inverse S&P proxy like the ProShares Short S&P 500 (NYSEARCA:SH) to capture gains in a downtrend.

That seems like an effective strategy on the surface, but I generally advise against it, and here's why.

An inverse ETF like SH will do very well (gain value) when the market goes straight down. (And of course it will lose money just as readily if the market goes straight up.) But markets rarely go straight up or down. And it would even rarer to actually know in advance when the market will go straight down.

The best we can know is the probability that an uptrend or downtrend will continue. And even when our probability proves correct, most of the time the market will move in some kind of zigzag or on-and-off pattern-which works against the inverse ETF.

Because tracker ETFs seek to replicate their underlying indexes, the underlying stock portfolios are rebalanced daily. And the compounded returns of rebalancing cause a little erosion when the market fluctuates.

Consider a $10,000 investment in an inverse S&P ETF. Your investment controls $10,000 of the underlying index portfolio. That value will expand when the S&P goes down, and contract when the S&P goes up.

Suppose the index goes down by 1% one day and then bounces back to where it was the next day. That second day advance is slightly larger in percentage terms-approximately 1.01%. (100/99 difference from 1.00 is bigger than 99/100 difference from 1.00.)

So at the end of the first day, your original $10,000 is up 1% and is worth $10,100. Then on the second day, your ETF is down 1.01% of the $10,100, which is about $101. So the index is unchanged for the two-day span, and you're down $1, holding only $9,999.

An actual short sale would have returned your original $10,000 on the second day, but the inverse ETF eroded a little. That kind of erosion is common in inverse ETFs, and even more so in leveraged ETFs.

The short-term up-and-down action (or down-and-up) nets a loss. The same erosion effect grinds on as long as there is fluctuation-which is almost always-and the bigger the fluctuation (volatility), the steeper the erosion.

But that doesn't mean inverse ETFs are always bad. They are useful tools when there is reason to expect prompt decline in an index. Such a bet will be right or wrong (depending on your insight and analysis), but will not suffer from debilitating erosion, because you'll have the answer very shortly.

Our ETF Investing System makes a different kind of directional bet. When our indicators turn negative, the Sell signal is not a time-specific prediction of decline. Rather, it says that market conditions are likely to bring a decline over the coming weeks (or sometimes months).

We don't know how long the decline will take to get started, and we don't know how long it will last, but we do know that our signals add value over time, and thus the system will pay off if we simply stick with it. And while there most surely will be up and down wiggles in the meantime, we won't be penalized for them.

Editor's Note: This article was written by Robin Carpenter of Cabot ETF Investing System.

Below, find some more great investing and trading content from MoneyShow:

How to Trade the VIX

A Three-Prong Approach to World Markets

Stocks or ETFs in 2013?

Twitter: @TopProsTopPicks
No positions in stocks mentioned.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.
PrintPRINT
 
Featured Videos

WHAT'S POPULAR IN THE VILLE