The Pros and Cons of Inverse ETFs

The problem is not that there are problems. The problem is expecting otherwise and thinking that having problems is a problem.

~ Theodore Rubin

I’ve mentioned inverse ETFs a couple of times lately, so I thought it might be a good idea to explain what they are and how to use them for those who aren’t already familiar with them. Inverse ETFs are exchange traded funds that rise in value when the index that they track falls in value.

If you believe the markets are going down, you can buy shares in an inverse ETF just like an individual stock. If you’re right, your shares will rise in value. But if the market rises, the share price of your inverse ETF will fall.

Inverse ETFs for Canadians

Inverse ETFs are a relatively new product. Some of them haven’t even been around for a whole year yet. As a result, they may have very low volume and limited chart records for you technicians out there.

American readers have access to an even wider variety of inverse products. Some of them are very liquid. I won’t cover them here, but a simple Google search will point you in the right direction. For Canadians, here are a few inverse ETFs that trade in Canadian dollars on the TSX:

Single Inverse ETFs

• HIX (Horizons Beta Pro S&p/TSX 60 Inverse ETF): This is a single inverse ETF that gives you 1x the daily movement of the TSX 60 Index. So if the TSX 60 is up 1% on the day, HIX will be down roughly 1% on the day, and vice versa.
• HIU (Horizons Beta Pro S&P 500 Inverse ETF): This is a single inverse ETF that gives you 1x the daily movement of the S&P 500 Index. This is also hedged for currency fluctuations “to the best of its ability”.
• HIF (Horizons Beta Pro S&P/TSX Capped Financials Inverse ETF): This single inverse ETF gives you 1x the daily movement of the S&P/TSX Capped Financials Index.
• HIE (Horizons Beta Pro S&P/TSX Capped Energy Inverse ETF): This is a single inverse ETF that gives you 1x the daily movement of the S&P/TSX Capped Energy Index.
• HIG (Horizons Beta ProS&P/TSX Global Gold Inverse ETF): This single inverse ETF gives you 1x the daily movement of the S&P/TSX Global Gold Index.
• CIB (Claymore Inverse 10 Year Government Bond ETF): This is the brand new Claymore ETF that allows you to effectively short the 10 Year Government of Canada Bond – a bet that interest rates will go higher. Canadian Couch Potato recently offered a critique of this new offering.

This is just a sampling of some of the main inverse ETFs available to Canadians. There are others that track individual commodities like crude oil, natural gas, gold and silver. These are also offered by Horizons Beta Pro, but are very volatile and very thinly traded. Proceed with caution.

Leveraged Inverse ETFs

Leveraged ETFs give you more than 1x the daily movement of an index. If you bought a double inverse ETF and the index it tracked went down 1% on the day, the ETF would be up roughly 2%. There are a number of double inverse ETFs out there, and even some triple inverse ETFs in the States. That seems like overkill to me, but if it works for some traders, I guess it’s OK.

There have, however, been some pretty strident critics of leveraged ETFs – both the bull and the bear (inverse) forms. Some have even speculated that the use of these ETFs may have contributed to the Flash Crash of May 6, 2010. I don’t know enough about the mechanics of these and their effects on the markets to render an informed opinion on the matter. I just thought I would let you know that the issue is out there, as it could lead to some type of new regulation of these products.

Here are a few examples of double inverse ETFs for Canadians:

• HXD (Horizons Beta Pro S&P/TSX 60 Bear Plus ETF): This double inverse ETF gives you 200% of the daily inverse move in the TSX 60. If the TSX 60 is up 2% on the day, your HXD shares will be down about 4% and vice versa. (The bull version of this ETF trades under the symbol HXU.)
• HSD (Horizons Beta Pro S&P 500 Bear Plus ETF): This double inverse ETF gives you 200% of the daily inverse move in the S&P 500 Index.
• HQD (Horizons Beta Pro NASDAQ 100 Bear Plus ETF): This double inverse ETF gives you 200% of the daily inverse move in the NASDAQ 100 Index.

Leveraged ETFs, whether regular or inverse, should be approached with caution and are not for novice investors or those who have a longer term outlook. They are strictly in the realm of the short term trader, as they will not accurately track the progress of an index over more than a few days.

Pros of Inverse ETFs

Here are a few reasons you might want to incorporate inverse ETFs into your overall investment strategy:

• You can make money in a down market: Markets move in both directions. Why be a slave to the upside?
• You can use inverse ETFs to hedge your portfolio: If you see a big dip in the markets on the horizon, but you want to keep some of your core long positions, you can mitigate some of the losses on your longs with gains from your inverse ETFs. In this sense, these effective short positions can act as a sort of portfolio insurance. For some people, this might make it less likely that they will panic out of core long positions.
• Inverse ETFs are a lot easier to use than other methods that allow you to profit from a down market like shorting, which requires a margin account (ie. investing with borrowed money) or using options strategies, which can be pretty complicated for the average investor.

Cons of Inverse ETFs

Here are a few reasons inverse ETFs might not be for you:

• As with any other investment, you can lose money if you’re wrong.
• Inverse ETFs, especially the leveraged ones, do not always track the underlying index very closely over long periods of time.
• Inverse ETFs, like regular ETFs, involve trading commissions. You will pay your broker a fee each time you buy or sell shares. If you’re using a discount broker, this might be as low as $4.95 per transaction, but it’s something to factor into your decision.
• Inverse ETFs have higher MERs (Management Expense Ratios) than their regular counterparts. For example, you can go long the S&P/TSX 60 via the XIU (iShares S&P/TSX 60 Index Fund) for a management fee of just 0.17%. Going effectively short the TSX 60 via the HIX, however, will involve a management fee of 1.15%. Those fees are already included in the price of the ETF, and account for some of the discrepancy between the ETF and the underlying index.

Are Inverse ETFs for You?

I can’t tell you for sure whether inverse ETFs are for you or not. It depends on your investment knowledge and your views on the stock market. I can tell you that I traded HXD briefly during the 2008 market downturn and experienced some whiplash because of the huge market rallies that punctuated the steep declines. I would much rather use the single version of the inverse TSX 60 ETF (HIX) as it’s less volatile than its leveraged cousin. The HIX, however, was not introduced until March of 2009 – just in time for the big market comeback.

There are those who will tell you to avoid inverse ETFs altogether. That may be good advice for some investors. But I think they can be a valuable tool if you take the time to do some research and truly understand how they work. Then again, I would say the same thing about any other investment as well. 😉

Do you have any experience or advice on the use of inverse ETFs? Do you have a strategy that has worked for you?