In principle, Inverse Exchange-Traded Funds (ETFs) are designed as a hedging instrument for share management.
This type of ETFs reflects the inverse performance of an index. They are also known as Short ETF or Bear ETF. It’s because they are not intended for long-term investment and are traded in a bear market.
These ETFs are highly speculative instruments designed for short-term trading on a daily basis. Therefore they are not suitable as a genuine hedging instrument for private Investors.
Since when Inverse ETF funds exist?
Inverse Exchange-Traded Funds have been around since 2005, and as expected they have aroused investor’s interest and been under active management since their inception in 2005. Because theoretically, short ETF should be able to hedge short positions for the first time by using a UCITS fund.
An investor with a certain hunger for risk can profitably participate in falling prices through leveraged short ETFs.
How do Inverse ETFs work?
Before one chooses to invest in ETFs it’s really important that the investor understands how do they work.
The illustration of leveraged and short ETF indexes have become possible through the development of swap-based ETFs. Under the guidelines of UCITS the physical mapping of ETF is not possible.
Since this is an open-end product, which means there are no term limits. Investors can buy and sell it at any time. Therefore, the short index underlying the ETF is structured in such a way that its return is short term. Normally, the calculation is made daily.
However, it must be stated that it is not due to the lack of quality of the traded ETF but rather will cause lies mathematically.
In fact, the performance of the Short ETF cannot be simply deduced from index development in real terms minus one. This is due to the path dependence. This phenomenon can best be explained by means of a concrete example:
What is meant by Path dependence?
For clarity's sake, compare the development of a long index with that of a short index - with daily adjustment.
Day 1: The Long Index rises 10% from 100 to 110. The matching Short Index falls 10% from 100 to 90 at the same time.
Day 2: The Long Index is again up 10% from 100 (originally 100) to 121. The Short Index falls again by 10%, from 90 to 81.
Looking at the overall performance after investing for two days, you can see what path-dependency means. The Long Index has gained 21% overall while investing in the Short Index has lost 19%.
The longer these analysis widths are chosen, the greater deviations can be observed. The real result is thus quite different from the commonly expected one.
Here it is noticeable that the index mechanism was from the 2nd day. A higher yield loss with the short ETF results.
Even if the simulated index level of the above example returned to the base positions. On the 6th trading day (i.e., + -0), the corresponding short ETF would show a fairly significant loss.
The comparison would be even more negative if one had opted for a 2x leveraged short ETF.
This undesirable effect can only be avoided by adjusting the hedging position daily to the new value. This is absolutely uneconomical for a normal private investor.
Examples of Inverse Funds
Dow Jones Short ETF, such as UltraShort Dow 3x ETF
ProShares UltraPro Short Dow30 (CUSIP 74348A178) seeks daily investment results before fees and expenses which are three times the inverse (-3x) daily performance of the Dow Jones Industrial AverageSM.
This ETF seeks a return that is -3x the return of an index or another target for a single day, as measured from one NAV to the next.
Due to the compounding of daily returns, ProShares returns over periods of time other than one day will likely differ in amount and possibly direction from the target return for the same period. This Short ProShares ETF seeks a return equal to -3x the return of an index or another benchmark for a single day, measured from one NAV to the next.
These effects may be more pronounced in funds with large inverse multiples and volatile benchmarks.
Investors should monitor their holdings daily in accordance with their strategies.
SPY Inverse ETF / Ultra Short SPY / S&P Bear ETF
SPY is the most recognized and oldest ETF, leading the ranking of the largest AUM (Asset Under Management) and the largest trading volume. The fund tracks the massively popular US S&P 500 index.
ProShares UltraShort S&P 500 (CUSIP 74347B383) seeks daily investment results before fees and expenses that are double (-2x) the daily performance of the S & P 500 index.
DAX Short ETF
The 3x Daily Short DAX 30 ETF (ISIN DE000A1YKTK4) was developed for the investors to achieve a three times daily leveraged short exposure to DAX. 3x daily leveraged short exposure means that the product should reflect three times the daily percentage change in DAX 30.
For example, if the DAX 30 would rise by 5% on a given day, the product would do so by 15% that day (before fees, expenses, and adjustments).
How can the securities portfolio be hedged with Short ETFs?
If one understands the functioning of the Short ETFs, then with the short-term use a hedge against the price losses can be achieved.
For example, DB X-trackers MSCI Emerging Market Daily UCITS Short ETF (WKN: DBX0G4) reflects the inverse daily performance of an index. Over the past six months, it has achieved a performance of around 10%. The total expense ratio is 0.95 per cent annually.
As per the 2003 Tax Act, formally the Jobs and Growth Tax Relief Reconciliation Act of 2003, cut the tax rate for individual investors on qualified dividends from securities and most ETFs to 15%.
Because you can later retain the taxes from the price gains. One usually prefers a hedge with short ETF instead of selling the stock. Of course, this strategy requires untapped capital.
However, the use of capital can be reduced by using, for example, a 2x leveraged short ETF. It must be made clear that the risk of loss will increase due to path dependency if the market does not fall in a short time and without strong fluctuations.
Another option for hedging, in addition to options and futures, is the so-called "blank sale".
What's with the short or blank or naked sale?
Short sale is the popular way for the investors to sell securities, foreign exchange or futures contracts that the investor does not own yet. The seller sells the assets by borrowing them from the broker and then buys them back at a much lower price.
This process is referred in trading as the blank sale or short sell. The seller nets profit by the difference between stock prices and purchase prices. He sells for example the russell 2000 at a price of 1500 and buys it back later at a price of 1300. The difference of 200 is his profit.
Short sale only works if the stock market is falling. For buying an inverse etf with a short sale requires a margin account to buy them from the ETF’s list.
The most important things to know about the Bear ETFs:
They enable the hedging of equities, bonds and commodities
They serve as an alternative to selling long positions, as the tax-exempt price gains are retained and the issuer risk is avoided if they were built before January 1, 2009
They should only be used as a hedging strategy for short daily returns
The capital investment can be reduced by multiple leverage
Conclusion: Are Inverse ETFs suitable for depot hedging?
Due to path dependency, Inverse or Bear ETFs are not suitable as a deposit guarantee for private investors.
But they are only to be used by professionals and institutional investors who have large assets under their management.
Like leveraged ETFs, short ETFs are also expensive to trade, but you can participate only if the market is falling.
Options and futures are cheap, but Bear ETFs are easier to handle.
They should always be used only as a short-term strategy but with caution.
For the normal private investor who wants to hedge his portfolio, risk reduction remains the only real way.