Have you ever played musical chairs? Do you remember those instances when there are only a few players left and the music is playing longer than normal with the tension building as everyone knows the music will end at any second? It reminds me a little bit of the feeling of this current bull market. With reports, at the time of writing this article, that it is the longest bull market in history, supported by what might become the longest economic cycle without a recession in history, the music feels as though it has been playing longer than normal.
Add on top of that, stock market valuation indicators like the Schiller P/E ratio and the Buffett Indicator hitting record, or close to record, over-valuation metrics, and one might ask how much further will the bull run before the bear market rears its head? Since the last two bear markets closely coincided with their respective recessions, investors might be nervous about the yield curve starting to invert (an economic signal that has predicted previous recessions with an uncanny accuracy).
As the music plays on, some might be encouraged to brush up on their bear market tactics, just in case. These are strategies that could help an investor profit in a bear market or at least hedge their portfolio (offset losses on bullish positions). One of these approaches is the use of Inverse Exchange Traded Funds (Inverse ETFs). These are mutual fund like investments that could be a simpler and potentially safer strategy for investing during a bear market compared to shorting or the use of options. Also, unlike shorting the market directly, inverse ETFs are eligible to be used in an IRA.
As with any investment approach, it is important to understand the pros and cons……the risks and rewards. Remember that smart investing is a process of managing risk factors while preserving as much of the reward as possible.
What Is an ETF?
As mentioned above, an ETF is, as its name indicates, a fund that trades on the open exchange. This is unlike mutual funds that do not trade on the open exchanges, but instead must be purchased directly from their respective purveyors. Because ETFs trade on the open exchange, on a per share basis like a stock, there are added advantages over mutual funds. For example, stop orders can be used on an ETF and many are optionable (opening the potential for additional risk management strategies). They are also not actively managed but are a passive fund. In other words, they track a basket of investments to mimic the value of either an index, sector, commodity or currency. Because they are passively managed, many have very low management fees that could be as little as one tenth that charged by a normal mutual fund.
ETFs have become very popular over the past few decades. SPY, the ETF that mimics or tracks the value of the S&P 500 index, has the distinction of being one of the most actively traded instruments in the entire stock market. Bottom line, ETFs could give you the diversification of a mutual fund with the transactional ease and liquidity of a stock.
What Is an Inverse ETF?
Inverse ETFs are designed to track the inverse relationship of another investment. They are most popularly used to generate inverse returns on the major stock market indexes and sectors. For example, SPY has an inverse equivalent, SH, that is designed to generate the inverse returns of the S&P 500. So, if SPY increases by 1.5% in a trading day, SH should go down by 1.5% and vice versa. This means if we were to see a bearish period of time in the market, we should experience a positive return using an inverse ETF like SH as our investment vehicle.
What Is a Leveraged ETF?
Inverse ETFs also have a wild sibling called leveraged ETFs. These ETFs track their respective indexes at 2X or 3X their normal rate. So, if SPY went down by 2% today, a 3X inverse ETF will increase by about 6%. This sounds wonderful, right? However, there is a catch that increases the risk of these vehicles. In order for the ETF to track their respective investments as a multiple, they need to use derivatives that require constant rebalancing to maintain the correct rate at which it is supposed to follow its target index. This frequent rebalancing causes a slippage effect over time that works against the holder of the ETF. This effect is even prevalent in regular inverse ETFs but is much, much more significant on leveraged ETFs; it is magnified by a choppy market where it changes direction more often. This means, if you hold an inverse ETF while the market goes sideways, you will typically lose money while the normal ETF breaks even. Be sure to read the prospectus of any ETF you are considering investing in to understand more about this risk factor.
Demonstration of ETF vs. Inverse ETF vs. Leveraged ETF Positions
To see this effect in action, let’s compare the returns of an index ETF to an inverse and 3X inverse ETF. Let’s say an investor bought all three ETFs on the 3rd of December 2018, just before the year end decline. Let’s see what happens over the next 3 months as the S&P 500 dropped and recovered.
Checking the position at the low point of December 26, SPY has lost 16.63%, SH has gained 18.82% and SPXU has gained a whopping 66.7%. Now let’s see how this investor would have fared after the S&P 500 recovered 3 months later on March 1, 2019. SPY broke even at 0%. SH lost 0.85% and SPXU lost 5.13%. Notice the slippage that accrued over a short period of time from the inverse ETF, and the significant slippage on the triple inverse ETF. This was only a 3 month period; now imagine if that 3X ETF was held over a few years. An investor could lose most or all of their investment just due to the inherent slippage these vehicles experience.
So, in light of all this information, how could an inverse ETF be used to benefit a portfolio in a bear market? The answer is, there are a several ways. Let’s explore two ideas…. an outright bearish investment and using an inverse ETF as a temporary hedge.
Bear Market ETFs
Prior to using this bear market strategy, an investor would first want to be confident that a bear market is indeed imminent. They would then simply buy and hold a bearish ETF, like SH. They now have a diversified short portfolio of the S&P 500 Index. However, they should not fall asleep and just hold this position indefinitely because bear markets are typically shorter than bull markets, so they would likely want to be ready to liquidate this position. Remember, average bear markets with a 35%+ decline, historically, have lasted about 2 years. Milder bear markets will typically last less than a year a majority of the time.
The risk when holding a bear market ETF is if you are wrong and the market is not bearish. This is where it is advisable to predetermine at what price to set a stop and get out of the position to limit risk exposure. Inverse ETFs are not a long term buy and hold strategy.
Leveraged Inverse ETF Bear Market Strategy
This is a short term hedging strategy that uses a leveraged inverse ETF. However, an investor only needs to buy enough shares to offset or partially offset the other holdings in their portfolio. In other words, if the market goes down causing losses in standard stock positions, the leveraged inverse ETF could be used to offset a portion or possibly even all of the losses. The benefit is that it allows the investor to reduce risk exposure without liquidating positions, creating tax implications or losing a dividend income stream.
Some of the challenges with this approach are the need for capital to invest in the hedge. Also, if the market doesn’t drop, the hedge wouldn’t have been needed, making it an unnecessary expense. So, investors who feel that the market is overdone and there is more risk to the downside than potential to the upside could use this bear market strategy to implement a hedge by buying a leveraged inverse ETF.
Once again, it’s important not to forget about the slippage issue when using this bear market ETF strategy. It is generally not advisable to use this hedge for an extended period of time for the sole purpose of reducing the risk in certain market environments. For example, those who initiated a hedge in December 2018, and whose portfolio performed similarly to the S&P 500 index, could have potentially cut their losses about in half for every $100K by simply using a $12K investment on SPXU. Then, when they closed out their hedge, they could re-invest that capital back into stock, dollar cost averaging down their portfolio compounding when the recovery ensues.
Bottom line is that inverse ETFs could be useful as a bearish strategy or hedge. However, always remember that due to their unique composition of short positions and derivatives, they can incur a slippage effect as the market fluctuates up and down over time.