Exchange Traded Funds (ETFs) are registered investment funds whose shares trade like a stock on the exchange. ETF’s can be bought or sold through the trading day at various prices. This separates them from traditional open ended mutual funds which are bought and sold throughout the day based on a single closing price at the end of the day. ETF’s can hold assets such as stocks, bonds, or commodities just like open end mutual funds. Most ETF’s track a particular index, such as the S&P 500 stock index.
Exchange Traded Funds – ETF’s – can be leveraged or non-leveraged. A leveraged ETF’s purpose is to deliver multiples of the performance of the index or benchmark that it tracks.
Some ETF’s can profit even if their underlying benchmark index drops in value. Such ETF’s accomplish this through the use of put and call options and other futures contracts (beyond the scope of this posting) and are known as inverse ETF’s.
Inverse ETFs (also referred to as “short” funds) track the opposite of the performance of the benchmark. Inverse ETFs are often used as a tool for investors to profit during downward moving markets. However there’s far more to inverse ETF’s than just profiting on market drops, and that has to do with tracking error.
Most inverse ETFs “reset” daily. This is because they’re designed to achieve their objectives on a daily basis. Their long term performance (weeks, months, and even years) can be completely different from the benchmark during that time frame.
For example, lets say an index has a starting value of 1000 with a leveraged ETF set to double the return of the index starts at $1000. On day one, if the index drops by 200 points it shows a 20% loss and finishes the day with value of 800. Supposing the leveraged ETF accomplishes its daily goal, it would drop 40% down to $600.
The next day, the index rises 20% increasing its value to 960. The ETF would rise by 40%, and would close at $840. Thus, over a two day period, the ETFs negative returns would equal almost 4 times that of the two day return on the index (a loss of 4% on the index vs. a loss of 14% on the leveraged ETF).
The graph above illustrates this point. Because the leveraged ETF drops farther day one, it’s increase day two isn’t as strong as the index and therefore we have “tracking error” over that two day period.
ETF’s with no leverage however have a greatly reduced tracking error, and while they won’t be as volatile up or down as a leveraged ETF, it will provide a closer correlation to the bogey benchmark index.
I’m confident that in the near future companies will create monthly reset ETF’s which will allow greater use of leverage. Currently the daily reset alternatives show too great a tracking error to use with a longer term “hedging” type of strategy that an investor may wish to employ in their investment portfolio.
The use of non-leveraged inverse ETF’s may be a good option to implement as a form of insurance or downside protection in some portfolios, for some clients. But it’s not for the faint of heart or those who don’t thoroughly understand the inner workings of such investment vehicles.
