Are Inverse ETFs a Good Way to Reduce Risk?

A reader writes in, asking:

“I recently learned about ‘Inverse ETFS’ that do the inverse of what the market does: up by 5% if the market is down by 5% and so on. Can these be a useful tool for scaling down risk in a portfolio?”

For most individual investors inverse ETFs are not an ideal method for reducing risk. Frankly, I would encourage most individual investors to stay away from inverse funds, especially leveraged ones.

For those unfamiliar with the concept: An inverse ETF seeks to do exactly the opposite of whatever the index in question does on a given day. For example, ProShares Short S&P500 seeks to provide -1x the S&P 500’s daily return. So if the S&P 500 goes down by 1% in a given day, this ETF should go up by 1%. There are also leveraged inverse ETFs that seek to provide a multiple of the opposite of the index’s daily return. For example, ProShares Ultrashort S&P500 seeks to provide -2x the return of the S&P 500 each day.

The problem with inverse ETFs isn’t that they fail to do their job. In most cases, they do a good job of delivering the targeted return each day. The problem is that, over an extended period of time, the math doesn’t work out the way that most people would intuitively expect.

For example, take a look at the following chart (made using Morningstar’s website). It shows the performance of the Vanguard 500 Index Fund (in blue), ProShares Short S&P500 (in orange), and ProShares UltraShort S&P500 (in green) from 1/1/2008 to 12/31/2009. (You can click the image to see a larger version.)

Over the period in question, the regular S&P 500 index fund lost approximately 20% of its value. Many people would therefore expect the inverse ETF to have increased in value by about 20%. But it didn’t. It only increased in value by about 1.2%. And the leveraged inverse ETF didn’t go up in value by 40%. In fact, it didn’t go up in value at all. It decreased in value — by every bit as much as the regular S&P 500 fund!

Why Do Inverse ETFs Work This Way?

The reason that inverse ETFs provide -1x the index’s return on a day-to-day time frame, yet something very different from -1x the index’s return over a longer time frame is simply math. Let’s look at a simple two-day example.

Imagine that a given index goes down by 3% on one day, then up by 1% the following day. Over this two-day period, the index will have provided a total return of -2.03% (because 1 x 0.97 x 1.01 = 0.9797, which is 1 minus 0.0203).

But an inverse ETF (going up by 3% in the first day, then down by 1% on the second day) doesn’t provide a positive return of 2.03%. It provides a positive return of 1.97%. That’s obviously a small difference. But when you compound such differences over an extended period, the result is that inverse ETFs will often provide a return that is very different from the opposite of the index’s return over that extended period. (And leveraged inverse ETFs will generally provide a return that is much worse than the the index’s return, multiplied by the applicable daily multiplier.)

If you want to make a bet that a particular index is going to decline in value on a particular day, inverse ETFs are a good tool for that purpose. But very few investors should be betting their financial future on such short-term fluctuations. For most people, if you want to reduce the degree to which you are exposed to stock market risk, the best solution is the simplest one: reduce the percentage of your portfolio that is allocated to stocks.