Finance Brokerage Explains: Inverse ETFs Investing Risks
The main goal of inverse exchange-traded funds (ETFs) is to earn inverse returns of the underlying indexes. To reach this goal, inverse ETFs usually use secondary securities including forwards, swap agreements, futures contracts & options. Inverse ETFs exist for uncertain and speculative investors and traders who look for tactical day trades in contrary to their respective underlying indexes.
Inverse ETF look for investment outcomes that are inverse on their benchmark performances for a day. For instance, an inverse ETF looks to track inverse performance on Standard & Poor’s 500 Index (S&P 500 Index). Meaning, if the S&P 500 Index gains 1%, ETF would automatically lose by 1%.
Inverse ETF have various risks and not advisable for risk-averse investors. It can only be suited for refined, and a risk-tolerant investor who is comfortable with risky scenario including handling inverse ETFs. The main risk varies on various investing risks that we’ll list down and discuss below.
(1) Compounding Risk
Inverse ETFs continued longer than one day will be affected by compounding returns. Because inverse ETF best used in a single-day investment, providing investment results that are greater than the inverse of its underlying index, the fund would perform differently from its investment objection for periods more than a day. Investors choosing to hold inverse ETF more than a day should manage and rebalance positions enable to mitigate compounding risk.
(2) Derivative Securities Risk
A lot of inverse ETF give exposure to employ derivatives. Derivative securities are somehow considered aggressive investments and expose inverse ETF for more risks, including correlation risk, credit risk, and liquidity risk. Swaps contract makes one party exchange cash flow of speculated financial instrument for cash flows against the other parts financial instrument for a specific period.
Swaps within indexes and ETFs were created to trace performance of the underlying indexes and or securities. The outcome performance of an ETF might not perfectly trace the inverse performance of an index because of the expense ratios and or other stuff including those negative effects of rolling futures contracts. It means, inverse ETF with swaps usually carry higher correlation risk and may not achieve greater degrees of correlation on their underlying indexes compared to funds that only operate index swaps.
(3) Correlation risk
Inverse ETFs are also at risk of correlation, In which could cause by various factors, including higher fees, transaction costs, expenses, illiquidity and investing methods. Even though inverse ETFs look for a higher degree of negative correlation for their underlying indexes, those ETF mainly rebalance their portfolios every day. That leads to higher expenses and transaction costs incurred for adjusting the portfolio.
Additionally, reconstitution and index re-balancing cases might cause inverse funds underexposed or overexposed in their benchmarks. Those factors could decrease inverse correlation among inverse ETF and its underlying index within the day of the case.
(4) Short sale exposure risk
Inverse ETFs could look for short exposure with the use of derivative securities including swaps and futures contracts, which may prompt the funds getting exposed to risky short selling securities. Increase in overall level on volatility and a decrease in the level of liquidity within the security of short positions are the major risks of short selling derivative security. Those risks bring lover short-selling funds returns, meaning a complete loss.