3 Things to Know About Inverse ETFs

by Susan J. Aluise | April 24, 2012 8:00 am

“Risk comes from not knowing what you’re doing,” Warren Buffett once said.

When it comes to investing in inverse or leveraged exchange traded funds (ETFs), a federal securities regulator wants to make sure long-term retail investors know what they’re doing.

The Financial Industry Regulatory Authority (FINRA) is gunning for broker/dealers that haven’t adequately explained the risks these nontraditional ETFs pose to investors who hold them for “more than a day.”

FINRA is bringing enforcement cases against brokerages that have made “unsuitable” sales of these ETFs, Bradley Bennett, the agency’s enforcement chief, told Reuters last Wednesday[1]. While Bennett declined to identify the brokerages, he said the cases also would include charges of improper or inadequate training for the brokers selling the ETFs.

Leveraged and inverse ETFs are different from regular ETFs that track an index or hold a basket of stocks, bonds, commodities or currencies.

Inverse ETFs are a bet against the index or other investment, the aim of which is to hedge your portfolio or profit during a down market.

Leveraged inverse ETFs aim to double or triple your bet[2] that an index is trending down. If you don’t have a margin account or are skittish about options, ETFs make it easier to short equities or other investments. While investors can achieve significant daily returns, they can lose big if they bet wrong. And the risk rises dramatically the longer you hold the position.

That’s why regulators have declared war on these ETFs and the brokers that sell them.

The agency’s concern about these ETFs is illustrated by the following case: From Dec. 1, 2008 to April 30, 2009, an index gained 2%, but a 2X leveraged ETF fell by 6%. A double inverse ETF tied to the same index fell by 26% over the same time period.

That’s FINRA’s way of saying caveat emptor.

If you’re still interested in betting on inverse and leveraged ETFs, here are three things you need to know before you ante up:

They’re Short-Term Investments

These ETFs are designed to achieve their objectives on a daily basis. If you’re looking to make a short-term tactical trade to benefit from quick market moves, you can cash in and cash out quickly. But if you plan to buy and hold, the performance of these ETFs becomes unreliable over time since fund managers “rebalance” their exposure every day. In other words, if you buy a triple-leveraged inverse ETF, hold it for six months and expect to do 300% better than the market, you’re likely to lose your shirt.

They’re More Vulnerable in Volatile Markets

Daily rebalancing tends to make inverse and leveraged ETFs far riskier in volatile markets. The ETF has to deliver the right multiple of the underlying index’s performance (or inverse) every day. If the index continues to rise, the ETF must increase its exposure. If the index continues to fall, the ETF decreases its exposure. But if the index pitches up and down, your return can end up being far worse than you expect over multiple trading sessions.

Costs Can Mount Quickly

Leveraged or inverse ETFs may be more expensive than traditional ETFs in two ways:

1) Because the daily resets could cause the ETF to show short-term capital gains that aren’t offset by losses, investors potentially could incur greater tax consequences.

2) Fees and expenses can be higher for leveraged and inverse ETFs. To compare fees and expenses for ETFs, check out FINRA’s Fund Analyzer[3].

The bottom line: Inverse and leveraged ETFs aren’t inherently evil, but they can be dangerous for long investors who follow a buy-and-hold strategy. These ETFs use sophisticated instruments like swaps and futures to amplify the daily returns of an index (or the inverse of that benchmark).

So the longer you hold these ETFs, the greater your risk of losing big time.

When considering leveraged or inverse ETFs, research them thoroughly and make sure the fund’s objectives match your own.

Also, be sure to review the valuable guidelines FINRA provides on its website[4].

  1. told Reuters last Wednesday: http://www.reuters.com/article/2012/04/18/finra-exchange-idUSL2E8FI9XH20120418
  2. triple your bet: https://investorplace.com/2012/03/the-triumphs-and-troubles-of-trebles/
  3. FINRA’s Fund Analyzer: http://apps.finra.org/fundanalyzer/1/fa.aspx
  4. valuable guidelines FINRA provides on its website: http://www.finra.org/Investors/ProtectYourself/InvestorAlerts/MutualFunds/P119778

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