D. Inverse ETFs

Why invest in Inverse ETFs?

Overview

Inverse ETFs are investment strategies that benefit from a decline in the underlying index that they track and vice versa. They are similar to taking a short position, with the difference that the downside of the inverse ETF is limited to the purchase price of the ETF as against having an unlimited downside risk with an open ended short position. In the same context, using a short position may be a better hedge as compared to an inverse ETF to hedge against a market decline.

Challenges

Returns on the inverse ETF may not exactly track the inverse of the underlying index because of ‘compounding risk’ resulting from the daily re-balancing of the position. This means that the original trade is closed on a daily basis and re-instated at the opening level the next day. Hence inverse ETF’s may be a useful investment tool for a shorter term horizon (as short as a day or two?) as compared to a longer term strategy.

Performance

A comparison of investing $100 in SPY vs SH (Inverse of S&P 500 index) shows that while the chart has a ‘inverse visual’ the actual cumulative returns are not perfectly inverse. SH lost 3.6% in the comparison period while SPY gained 0.32%.

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