Some Funds Win When Others Lose. But When the Others Win …
In a shaky stock market, you may be enticed by funds that promise to make money whenever stocks fall.
There is a group of funds that actually fulfill this claim. Yet most people should beware: They are definitely not recommended for the casual investor.
They are called inverse exchange-traded funds, and as their name implies, their value moves in the opposite direction of their benchmarks. When the stock market rises, they fall; when the market falls, they rise.
In addition, some of these funds are leveraged, which means that they bet against their benchmarks by a factor of, say, two to one or three to one.
Take the ProShares UltraPro Short S&P 500, an inverse fund that shorts the S&P 500-stock index at three-to-one leverage. On Dec. 17, the E.T.F. closed up $2.63 for a gain of 6.10 percent for the day while the S&P 500 fell 2.08 percent. (Because of fees and other issues, index funds, inverse or not, typically don’t track indexes exactly.)
But those impressive results don’t come easy. Inverse E.T.F.s aren’t designed for the average do-it-yourself investor. You aren’t likely to find them offered in your 401(k) for a good reason: Inverse E.T.F.s can quickly destroy the value in a portfolio.
Instead, inverse E.T.F.s are designed to function as a very short-term trading strategy for extremely knowledgeable investors.
“These funds are built for short-term speculation. They’re designed to be outliers,” said Paul Justice, director of data methodology for Morningstar. “Individual investors find their way into these products, and if they’re not careful about their holding periods, they can be in for an unpleasant surprise. And the more leveraged the fund is, the more unpleasant the surprise will be.”
At first blush, an E.T.F. that gains when the market falls may sound like an easy way to hedge a portfolio without resorting to more complicated strategies involving options and short-selling. Leveraged E.T.F.s offer the potential for greater rewards (and, naturally, risks) without the need to open a margin account and run the chance that, if the market moves in the opposite direction, the investor could be forced to raise cash by liquidating profitable holdings, triggering taxes on any gains, as well as possible fees.
The benefits of an inverse E.T.F. can be valuable — but only for a day at a time, said Greg McBride, chief financial analyst for Bankrate.com.
“This is trading, not investing,” he said. “Inverse E.T.F.s are designed to track daily movements, not long-term movements.”
Mr. McBride added: “If you have an inverse S&P 500 E.T.F., it’s designed to rise 1 percent today if the S&P 500 falls 1 percent today. But if the S&P is down 5 percent over the next 12 months, don’t expect the inverse to be up 5 percent.”
Consider that while the S&P 500 was down about 5 percent for the year as of mid-December, the ProShares UltraPro Short S&P 500 had a year-to-date loss of 18 percent. By the close of trading for the year, however, the UltraPro ETF was up 2.3 percent for the year, compared with the S&P 500’s loss of 6.2 percent. Although the fund did finish up, it was well off its three-to-one short ratio for the year.
That’s because inverse funds are rebalanced at the end of each trading day to restore the targeted risk exposure. Over more than a day or two, that daily reset can compound the fund’s exposure to a dangerous degree. Yet the fund’s benchmark simply continues to make daily gains or losses with no rebalancing, said John Swolfs, chief executive of Inside E.T.F.s, a four-day, 200-speaker annual conference on E.T.F.s organized by Informa Exhibitions USA.
“If you can pick and choose your days right, you can do well,” he said, “but if you think you’ll buy this on Monday and sell it on Friday, your returns won’t be good.”
Pro Shares offers 62 inverse E.T.F.s, said Michael Sapir, the company’s chief executive.
“They’ve been tested through the tech boom and the financial crisis, and they all acted to do what they advertise,” he said.
Even so, for individual investors looking to protect themselves from market reversals, better strategies probably include conservative asset allocation with holdings of bonds and even cash.
“If you’re sitting on the trading desk at one of the big Wall Street banks, this is probably something you’re very familiar with and it’s not your first rodeo,” Mr. McBride of Bankrate.com said. “But for the individual investor, short-term strategies are just a fancy way of saying ‘market timing.’ And the biggest danger individual investors have is themselves.”
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