Inverse ETFs

Inverse ETFs are a feature in the US markets. The simple idea is that they operate inversely to the index they track. So for example an inverse S&P500 ETF will rise as the S&P500 falls and fall as it rises.

You can also find these as geared products – such as a 2x or 3x inverse ETF. As this implies, that will amplify the move by either 2x or 3x respectively.

This could be a great idea for those wanting protection as markets fall.

BUT, problems

The biggie is tracking error. Inverse ETFs really only work well on an intra-day basis. In fact, their listing documents stress they are designed for holding during the day and exiting before the day’s close.

For example, below is the chart of the S&P500 over the last year with the SH ETF and the SDS (which is a 2x so should do double the index). Yet the first two are both down the same percent while the 2x is actually 3% worse than the index whereas it should be up some 5%.

S&P500 inverse ETFs (1 year)

Over a six-month time frame, these inverse ETFs are at least making money while the index has fallen 9.2%. But they both lag behind the gains they should return, respectively +9.2% for the SH and +18.4% for the SDS yet the returns are 6.5% and 11%.

The Nasdaq 3x inverse has the same problem as you can see below. Over 1 year the index is off 12.7%, but the ETF is down 8%. It’s better over six months – the index lost 19.6% and the ETF is up 39.2%. But as a 3x inverse the ETF should be +58.8%.

Nasdaq 3x inverse ETF (1 year)

ProShares Short S&P500 (NYSE code: SH)

• SDS offers 1x leveraged daily downside exposure to the S&P500.
• TER: 0.88%

ProShares Short UltraShort S&P500 (NYSE code: SDS)

• SDS offers 2x daily downside exposure to the S&P500.
• TER: 0.90%

ProShares UltraPro Short QQQ (NYSE code: SQQQ)

• SQQQ offers 3x inverse leveraged daily exposure to the Nasdaq100.
• TER: 0.95%

Do we like them?

Depends on why you want to use them.

If you’re using them for trading, then sure. But traditional derivates on indices are also worth a look.

If you’re a long-term investor, what’s the point? Markets will recover and rather use the cash to buy more vanilla ETFs that will rise when the market recovers. And timing the market is hard. Real hard.

Simon Brown

At Just One Lap, we are big fans of passive investment using ETFs. In this weekly blog, we discuss ETFs on the local market and the factors you need to consider when choosing an ETF. If you have wondered how one ETF differs from another, this is where you can find out. We explain which index each ETF tracks, what type of portfolio could benefit from holding each ETF, and how the costs will affect your bottom line.