Why An Inverse ETF Is A Bad Choice, Even In This Economy

2011 August 22
by Kyle Bumpus
from → Mutual Funds And ETFs

During every recession, many “intelligent” investors (and I use this term somewhat disparagingly) set out to take advantage of the economic turmoil by shorting stocks: that is, selling stocks they don’t own with the intention of buying them back later at a lower price. To be sure, there’s a lot of money to be made by shorting stocks…if you get it right. The problem is, the market can often stay irrational longer than you can stay solvent, to paraphrase the great economist John Maynard Keynes. Inevitably, the ever-innovative financial industry decided to help investors shoot themselves in the foot more easily (ohh, and collect healthy fees too) by introducing the inverse ETF.

What Is An Inverse ETF?

Inverse ETFs attempt to do exactly what it sounds like: deliver to investors the upside potential of going short without the extreme downside risks of naked short selling (you can theoretically lose an infinite amount of money shorting stocks whereas you can only lose the amount invested with an inverse ETF). That is, if the S&P 500 should drop 10%, an inverse S&P 500 fund should rise about 10%. I say “should” instead of “will” because inverse funds are quite expensive to own and, as always, expenses act as a drag on returns. We’ll get to this in a moment.

The Advantages of Inverse ETFs

The main advantage of any inverse ETF accrues mainly to the issuer of the ETF. Seriously. But there are also some advantages to investors over traditional shorting. As stated before, owning a short ETF theoretically limits your losses to 100% of what you invested while naked shorting could potentially incur an infinite liability. This is a serious advantage in theory, but in practice it’s merely a minor one because let’s be honest…what experienced trader would be foolish enough to short a stock as it rises from $10 to $100?

Other advantages:

  • Simpler to own – Shorting stock can be somewhat complicated. For example, you have to pay the investor from which you are borrowing the shares any dividends paid while you hold the borrowed stock. You have to meet your broker’s margin calls should things go against you, etc. In short, you have to pay attention. Even though most of the above is done automatically by your broker these days, owning an inverse ETF is much simpler: you just have to buy it and monitor the price.
  • You don’t have to worry about there being shares available to borrow – Obviously, you can’t borrow a share stock of some stock or ETF if there are none available to borrow. This won’t be a problem if you’re trying to short a large-cap stock or one of the broad indices out there (such as the S&P 500), but if you’re looking to short something more specific, the existence of an inverse ETF can be a life-saver (not that I’m suggesting you do this).
  • Inverse ETFs make speculation much easier - This could also fall into the “disadvantages” category, but I’ll include them here as well. Do think think the market is in for a crash? You could always go long bonds with the majority of your portfolio and buy an inverse ETF with a small portion of your portfolio in order to profit from the crash. If the market doesn’t crash, you won’t have lost too much. But if it does…!
  • They exist for every freaking asset class imaginable – Seriously. There’s an inverse gold ETF (several, actually), an inverse silver ETF, an inverse treasury ETF, an inverse agricultural ETF, etc.
  • ETFs are so hot right now – Seriously. You’re not cool if you don’t own at least one.

Disadvantages Of Inverse ETFs

The disadvantages of ETFs are similar to their advantages. It just depends on how you look at it.

  • Simpler to own – Predicting short-term market movements amounts to gambling, pure and simple. While gambling is fun, most experts will tell you to do your gambling in Vegas, not your retirement portfolio. I agree with the experts on this. Making gambling easier is a disservice to investors.
  • Inverse ETFs make speculation much easier - See above. An inverse ETF list reads like a “do not invest in this narrow market sector” list. Additionally, there are double inverse ETFs and I think there is actually a triple inverse ETF! That kind of leverage simply has no place in any individual investor’s portfolio.
  • Costly - An inverse ETF will generally sport an expense ratio between 4 to 6 times higher than its “long” index fund counterpart. But expense ratios aren’t the whole story here. Inverse ETFs incur all the regular expenses involved in shorting a stock or index that you would have to pay otherwise (on top of their generous management fees). And like all ETFs, you’ll have to pay a brokerage commission to buy and sell them. Even though discount brokers like Tradeking and Zecco are dirt cheap these days, every little bit counts.

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One Response
  1. 2011 August 23

    While you make some great points that every investor should consider; your article misses the most important advantage of inverse ETFs. Using ETFs as a hedge, within a diversified portfolio, provides the most efficient means of hedging assets that are temporarly overvalued. This allows the portfolio manager the freedom to keep a portfolio of stocks, continue to collect the dividends, and not incur capital gains on a sale.
    It is very difficult to find investments with a negative correlation in portfolio asset allocation. Inverse ETFs have a near perfect negative correlation to REDUCE RISK in a portfolio!
    I have written an article titled “Examples of Correlation – Problems with Correlation of Asset Classes” that addresses this issue.

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