Inverse ETFs

ETFs have grown tremendously since the launch of the first ETF in 1993. The chart below is from BlackRock’s iShares website and illustrates ETF growth.

The most notable benefits of ETFs are their trading flexibility. ETFs are priced throughout the trading day, and because ETFs trade like stocks on an exchange, you can buy them on margin and place limit and stop orders. You are able to trade it like a normal stock, but it is a package of 500 or more stocks. Trading flexibility, however, can be a double-edged sword. The ability to trade anytime is a benefit to busy investors and active traders, but that flexibility can draw some people to trade too much. As John Bogle, Burton Malkiel, Warren Buffet, Benjamin Graham, and other long-term investors have all published via various mediums, a high turnover of a portfolio increases its cost and reduces returns. In just 20 years, ETFs have gone from relative obscurity to accounting for 40% (as of 2011) of daily trading volume. However, these products do exactly what they are supposed to do: reflect market sentiment. In my opinion, I believe regular investors can benefit greater by following a more conservative, time-tested strategy, such as investing in an index fund by means of dollar cost averaging.

One of the most interesting ETF products is inverse ETFs. Inverse ETFs short the index it is tracking. For instance, Direxion Daily Large Cap Bear 3X Shares (NYSEARCA: SPXS) moves opposite the S&P. The fund seeks daily investment results of 300% of the inverse of the performance of the S&P by investing in futures contracts, options on securities, indices and futures contracts, equity caps, swap agreements, forward contracts, short positions, and reverse repo agreements. For example, today the S&P was down 1.1% and the SPXS was up 3.3%. If tomorrow the S&P is up 0.5%, the SPSX will be down 1.5%. Moreover, if the S&P follows with a 2% drop, the SPXS will rise 6%. Keep in mind that not all inverse ETFs seek an investment result greater than 100% and some will move exactly 1-1 opposite of its respective index.

Inverse ETFs provide an easy means for a regular investor to hedge their bets by indirectly investing in complex derivative products. However, as mentioned above, this increased flexibility can cause some traders to trade too much.

What are your thoughts on inverse ETFs?