You've studied charts over time. You understand the fundamentals behind price movements and are convinced the market is going to drop. So you decide on an inverse index exchange-traded fund (ETF) as your instrument of choice to capture the downward move. Like clockwork, the market starts to decline. It looks like your research is going to pay off big. This is particularly true, since the inverse ETF you purchased is leveraged to provide three times the performance of its underlying index in the opposite direction. You couldn't be happier and are eager to celebrate your unrealized gains. You go on vacation and the market keeps dropping. The inverse-leveraged ETF must be raking in profits. It looks like, at a minimum, the trade will pay for this vacation. You return home, ready to cash in your winnings with the inverse ETF. As you pull up your broker's website, you stare with disbelief at the numbers. Your trade is now down 25%. How can this be?
"What a scam," you exclaim, and swear never to trade an inverse-leveraged ETF again.
Believe it or not, many traders suffer a similar fate. Take the 2008 bear market for example. Inverse real estate-based ETF's and inverse financial ETFs actually traded substantially lower during that extremely bearish year.
Are these inverse ETFs set up just to scam investors? No. They do exactly what they are designed to do. These long-term portfolio "bombs" are designed to follow the inverse of the daily moves of the underlying instruments. The keyword here is "daily." The inverse ETF only follows short-term daily movements. This may seem difficult to understand at first, but it's actually very simple.
Each day, the leveraged ETF needs to be rebalanced. This costly rebalancing eats into the fund's profits and hurts long-term growth. Often, costs outweigh profits, which can create the aforementioned ill-fated scenario. There are also other factors at work, including path dependency and nuances in the compounding of the net asset value (NAV). Therefore, inverse-leveraged ETFs are suitable only for day-trading and not long-term holdings.
But what should investors to do if they love the idea of inverse ETFs, but want to hold them long-term? I've discovered one inverse ETF that is suitable for the long-term. Unlike its brethren, this inverse ETF shorts stocks rather than indexes. Therefore, it does not have the issues associated with most inverse ETFs. It simply holds short positions in a variety of stocks that managers have identified as weak. This ETF is the Active Bear (NYSE: HDGE).
Active Bear is the right choice if you want to hold an inverse ETF for the long term. It can also be used, as its ticker suggests, as a hedging tool for your long portfolio. The downside to Active Bear is its high expense ratio of 3.3%. This is because it costs more to hold a short position than a long position since shares are being borrowed. The top holdings of this ETF include Citigroup (NYSE: C), Carmax (NYSE: KMX) and Green Mountain Coffee Roasters (Nasdaq: GMCR). Although I don't own this ETF, I like checking its holdings for short investment ideas. It's almost like having a team of analysts working for you by following the ETF's short positions.
Risks to Consider: Remember, inverse ETFs are designed to mimic the daily action of the underlying index. They are rebalanced nightly, which makes them inappropriate for long-term holdings. But Active Bear can be held overnight without the rebalancing risk. But also remember that it has a high expense ratio and you are going against the market's inherent upward drift every time you short or buy this inverse ETF. Always position size correctly and use stops regardless of how certain you are with your analysis.
Action to Take --> If you are bearish on the stock market for the long-term, then Active Bear is a better choice than index-based inverse ETFs. If you just want short candidates, then this ETF also serves as a great research source. Keep your eye on its holdings for more complex investment ideas.