The Risks of Inverse and Leveraged ETF's: A Word of Caution

In recent years there has been a rapid expansion of the ETF market as a solution to provide clients with low cost solutions that can provide a great deal of liquidity and transparency. As the ETF market place has grown, it has reinvented itself in many ways. Two of those ways are inverse ETF’s as well a leveraged ETF’s

What is an inverse ETF ???

Inverse is simply what it states. If you were to be of a bearish view and wished to purchase an investment that would bet against a market index such as the S&P 500, an inverse ETF can do this on your behalf. The position has a negative or opposite correlation to the stated benchmark investment.

Advantages...The primary advantage is that the alternative of shorting a traditional ETF will provide you with a market position of potentially unlimited losses. When you short a stock or any investment, you are borrowing that security from a broker dealer on margin with the obligation that you will return it when you close the position or receive a margin call. In order to do so, you must go back into the market place and buy it back. This is done through what is called a rehypothecation agreement. Since there is no limit to how high a security may go, it is essentially an unlimited risk. When purchasing an inverse ETF you have a loss limited to the amount of you investment and nothing more.

Disadvantages…There are many disadvantages, but the primary is the internal structure of the inverse ETF. Inverse products get their negative correlation by using option and futures contracts as well as credit default swaps. This is a much more complex trading approach than the average investor will understand. However the most important components to understand are first of all the counterparty risk. When a swap is bought or sold this a legal agreement by which one party agrees to act under certain circumstances. For example should you currently own gov’t bonds issued against the Greek Government and you wished to protect your losses, you could purchase a Credit Default Swap (CDS) on the risk of the bonds not paying off. Yet on the other end of that trade there is another counterparty whom may not be able to meet that obligation. The CDS market in our view has grown out of control and needs to be controlled a bit more rationally such as the typical equity options market. The CDS market is essentially the wild west of investing, where the obligations on the other end have been broken up into numerous parties that have become almost impossible to track. This is unlike the traditional equity options market which has a much tighter set of rules and margin requirements that maintain a more orderly marketplace. Nevertheless, CDS agreements are typically the primary vehicle utilized in these inverse ETF’s. It should be noted that such defaults by counterparties have been extremely rare to date.

As a result of using these derivative instruments, there is a time value associated with them. Options contracts expire at a certain point, so the relationship of the inverse ETF is not always going to be 1 for 1 in its performance. Just because there is a 10% annual decline in the S&P 500 does not guarantee that you will have a 10% profit. This is sometimes referred to as slippage.

Another issue to be considered is that of the internal expenses. As a result of the active nature of these products, they do not have the typical low expenses that are associated with the traditional long only ETF.

Leveraged ETF’s

A leveraged ETF can be either long or short a market index. However they typically attempt to achieve 200%-300% of the performance of the underlying market index. In doing so they have all of the above mentioned risk factors…and more !!! The ability to do this is through even further added leverage. Yet the most important factor the average investor needs to be keenly aware of is the reset factor.

For example let’s imagine that you purchase a position that is long the S&P 500 at a ratio of 300%, and the price at the time of purchase was $10 per share. Should the market move in the opposite direction and decline by -2% that day you should theoretically have lost -6%. Your $10 per share position should be worth $9.40 per share. Yet the next day the 300% leverage factor is not based upon your original purchase. It is rather based upon the previous days close to accommodate new buyers that day. Now let’s assume you have another negative day and the market falls by -0.5%. Your decline is theoretically 3x at -1.5% of the previous close of $9.40 not the $10.00 you paid. That brings you to $9.26 per share. As you can see in a rapid price movement away from the position you have taken, these losses can quickly accelerate.

The actual pricing is rarely this precise as a result of the slippage mentioned above. Yet the factors of risk are quite real. When purchasing these types of securities, it is important to use extreme caution. These are vehicles designed for highly sophisticated traders, and not of great use in a sound long term investment or financial plan. Should your financial advisor suggest something of this nature, it would be prudent to question his knowledge of these products. Unfortunately not all investment professionals are as aware of these risks as they should be.