Commodity funds have brought the individual investor access to both hard and soft commodities. Many of these products were not previously available for portfolio allocations on such a broad scale and are leading to changes in the way they are applied in the development of both large and small portfolios.
Like leveraged products, inverse ETFs use gearing to provide their expected returns. Gearing is a means of measuring financial leverage, specifically it is the ratio of leverage to equity. In the case of a normal inverse ETF, the gearing ratio will be 1. With a leveraged short fund the gearing might be 2 or even 3 times. There are many more leveraged short products than products that provide inverse exposure. The inverse funds exhibit the same traits as the leveraged funds in terms of compounding and rebalancing, but those effects are muted because of the low gearing in the products. The effects are also dependent on volatility and will increase and decrease proportionally.
Essentially, like leveraged products, these funds hold swaps to achieve their exposure. A short S&P 500 fund would hold a swap, paying the returns of the index to the counterparty. If the index trades up on any given day, the ETF would have to pay returns on the index to the counterparty, causing the value of the ETF to decrease. If the index trades down, the ETF would be receiving the return of the index, thus driving its net asset value (NAV) higher on the day.
In order to achieve the daily return of the index on a rolling basis, the funds will reset their holdings daily in the same manner as the leveraged products. Inverse funds bring an important tool to the investing community in the form of long negative exposure.
Trading and liquidity
You can trade and access liquidity using inverse ETFs in the same manner as any other ETF. If you are a buyer of the inverse S&P fund, for example, you can buy it in the market electronically or you can go to a liquidity provider for an NAV-based execution or for them to provide you with a large-block market. In this scenario, the liquidity provider (LP) would be shorting the inverse S&P fund to you, so they effectively would have long exposure to the S&P 500. In order to hedge itself, the LP would have to sell some form of correlating exposure, either the basket, futures, or another derivative to offset the long exposure. This is opposite the scenario of the LP selling a long-based ETF to a client.
Some important factors about the inverse ETF should be understood when trading them. They are one way to achieve downside market protection in accounts that typically cannot achieve that type of access, such as IRAs. You can buy a product that will increase in value as the market declines. This opens up an entirely new way to position your portfolio. Formerly, long-only investors had the opportunity to have long market exposure or cash; now they can take advantage of, or protect against, expected down moves in the market. This could have a profound effect on the way people manage their investment portfolios in the future.
Another characteristic of inverse products is the changes in their exposure. For those who were able to short listed products previously, these products offer a way to short the market without the risk of unlimited losses. When you short a stock or ETF in the market, you are exposed to that position going potentially infinitely higher. Your portfolio could suffer devastating losses. When using an inverse ETF, the losses are limited to the amount that you invested into the position. When you are correct in your positioning, however—when you are using an inverse ETF and your underlying exposure is going down—your exposure to that position is also increasing. As the market is moving lower, your ETF NAV should be moving higher, increasing your notional exposure to the position, if the cumulative direction is correct. This is the opposite effect of a typical short position in which your notional exposure decreases as the market moves lower.
Although inverse ETFs do provide a very important and functional tool, how they are used is critical to investment performance. Distinguishing investment goals and time horizons and understanding what potential market activity can do to the performance of your portfolio is extremely important.
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Leveraged and inverse exchange-traded products are not designed for buy-and-hold investors or investors who do not intend to manage their investments on a daily basis. These products have a "most aggressive" investment objective and require an executed Designated Investments Agreement for purchase. These products are for sophisticated investors who understand the risks (including the effect of daily compounding of leveraged investment results) and who intend to actively monitor and manage their investments on a daily basis.
Exchange-traded products (ETPs) are subject to market volatility and the risks of their underlying securities, which may include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. ETPs that target a small universe of securities, such as a specific region or market sector, are generally subject to greater market volatility, as well as to the specific risks associated with that sector, region, or other focus. ETPs that use derivatives, leverage, or complex investment strategies are subject to additional risks. The return of an index ETP is usually different from that of the index it tracks because of fees, expenses, and tracking error. An ETP may trade at a premium or discount to its net asset value (NAV) (or indicative value in the case of exchange-traded notes). The degree of liquidity can vary significantly from one ETP to another and losses may be magnified if no liquid market exists for the ETP's shares when attempting to sell them. Each ETP has a unique risk profile, detailed in its prospectus, offering circular, or similar material, which should be considered carefully when making investment decisions.