Inverse ETFs

In my last Portfolio Update article, which I published on April 23, 2019, I said in the abstract section of my article “Hedge Funds are shorting VXXB in a bet that volatility will remain low, I find this a bit risky because of the inverted yield curve, high oil prices and frothy markets.  A short-term bet (as in days/weeks) against volatility is suitable for current market conditions (as in the next few weeks), but I’m contemplating going long on VXXB with $50,000 (5% of my principal) in the early/late fall (I won’t be long for more than 2-4 weeks).”  Rather than play with 5% of my principal, I took a step back from the aggressive plan and limited myself to only investing no more than 2% of my principal in either Volatility Products or Bear ETFs, in order to prevent myself from making a big mistake/dent in my portfolio.

Rather than “going long” on VXXB, which is a Volatility Product, I instead bought shares in two Bear/Inverse ETFs, which I found a whole lot easier to understand how they work/operate vs. Volitilty Products such as VXXB.  Now before getting into which two Bear ETFs I invested in and what makes them unique, I’ll first seek to define an Inverse ETF and some of their advantages.

To answer the question of what is an Inverse ETF, Investopedia states “An inverse ETF consists of various assets and derivatives, like options, used to create profits when the underlying index declines in value. Basically, it’s an index ETF that gains value when its correlating index falls. For example, the Short DOW 30 ETF (DOG) profits when the DJIA index goes down.”  Before getting into the risks and disadvantages I find with Inverse ETFs, two significant advantages are:

  • If you have a trading or brokerage account that doesn’t allow you to short-sell assets, you can purchase an inverse ETF to give you the same investment position as you would have with a short ETF or index.  
  • Investors won’t have to use a margin account as he/she would when shorting an investment. Even though inverse ETFs act like short positions, you actually purchase the ETFs.

Now on 5/9/2019 I bought 375 shares in Direxion Daily S&P Bear 1X Shares (ticker: SPDN) at $27.93 a share and on 5/10/2019 I bought 125 shares of ProShares Short QQQ (ticker: PSQ) at $28.83 a share.  To understand the individual strategies of both SPDN and PSQ, I’ve pulled each both their respective descriptions off their websites and if you find Inverse/Bear ETFs of interest here is a list of other equity Inverse ETFs:

  • Direxion Daily S&P Bear 1X Shares (SPDN): The investment seeks daily investment results, before fees and expenses, of 100% of the inverse (or opposite) of the daily performance of the S&P 500  Index. The fund, under normal circumstances, invests in swap agreements, futures contracts, short positions or other financial instruments that, in combination, provide inverse (opposite) or short exposure to the index equal to at least 80% of the fund’s net assets (plus borrowing for investment purposes). The index is a float-adjusted, market capitalization-weighted index. The fund is non-diversified.
  • ProShares Short QQQ (PSQ): This ETF offers inverse exposure to an index comprised of the 100 largest nonfinancial securities on the NASDAQ, making it a potentially attractive option for investors looking to bet against this sector of the U.S. economy. It’s important to note that PSQ is designed to deliver inverse results over a single trading session, with exposure resetting on a monthly basis. Investors considering this ETF should understand how that nuance impacts the risk/return profile, and realize the potential for “return erosion” in volatile markets. PSQ should definitely not be found in a long-term, buy-and-hold portfolio, but may be a useful tool for more active investors looking to either hedge existing exposure or bet on a decline in the top nonfinancial NASDAQ securities. Investors also have the option of simply selling short a traditional NASDAQ fund, though that strategy will generally involve greater potential losses than utilizing an inverse ETF.

I was able to sell both PSQ and SPDN for a very small meaningless profit, I made around $300 total, but rather than promote these Inverse ETFs, I found them to be risky and a bit of a gimmick.  The first issue I find is what I would refer to as long-term erosion. Essentially, over a long-term perspective (think 10 years) the stock market has a very high probability of ending the decade higher than it started.  Hence, an S&P 500 Inverse ETF is almost destined to produce an investor negative returns of a long-term period. Therefore, the utilization of Inverse ETFs in order to produce positive returns is reduced to market timing, which is risky business.  

In order to explain further, I’ve included charts from PSQ, SPDN and the S&P 500.

As one can see by examining the three charts, PSQ and SPDN trend downward, while the S&P 500 chart trends upward long-term.  With regards to the S&P, it does show two significant market dips that come about around 2003 and 2008. These two respective time periods with market declines is where the utilization of PSQ and SPDN could be advantageous, but in order to do so, an investor is faced with the difficulty of predicting and timing an overall market decline. While another possible use, would be within a risk-parity constructed portfolio. Rather, I find shorting Bear ETFs an easier route and I’ll be possibly looking to do so right after a significant market pullback/correction.

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