4 Reasons to Avoid Buying Inverse ETFs
By Grace Chen
on March 6, 2009
Photo Credit: www.SquawkFox.com
The explosion of growth in the ETF industry has been both a boom and a bust for investors looking to make top dollar in the stock markets. Although the vast selection of ETFs gives investors more consumer choice, some ETFs are simply not worth trading. More and more traditional ETFs that help investors buy or sell a vast variety of investments and entire sectors at a time are convenient, but the new inverse and leveraged ETFs are leaving most with a headache.
The Derivative Effect
Building a solid leveraged and inverse ETF is difficult because the methods used to produce the leverage and inverse reactions are nothing more than derivatives for the average investor. ETF managers have to re-create a portfolio that mimics something else (the derivative) while maintaining the quality of the ETF. To do so is merely impossible, and today’s inverse ETFs are more like alchemy than investing.
The Market Effect
Not a single ETF will ever trade perfectly to its net asset value because of both the spread between bid and ask prices, as well as the fact that ETFs are a derivative. Many investors have no problem paying an extra few pennies to secure shares in an ETF, and often, the ETF managers have to re-value their ETFs with NAV to ensure the two numbers never diverge more than a few percentage points. The market will never price an ETF to its NAV perfectly, but it can do so in such a way that the prices are close. With leveraged and inverse ETFs, the divergence between NAV and share price is generally larger as a result of leverage and the inability of ETFs to maintain a link to their derivative holdings.
Volatile Markets Lend No Help
Certainly, the case can be made that if the markets were less volatile and more fluid, inverse and leveraged ETFs
would perform better to their investment clone. However, the more popular ETFs, such as the leveraged inverse fund UYG, is embedded in an industry that sees more volatility than ever before. With the banking industry practically advancing by 10% one day and falling by 15% the next, these funds will have an incredibly hard time averaging and leveraging the changes in stock prices to make the funds relevant to their supposed holdings.
Invest it Better
The only way to accurately achieve leverage and produce profits on the inverse changes in an investment is to do so in an analog manner. Though it may be “so 1999” to place short trades and utilize margin accounts, this is the only effective way to sustain any measurable amount of continuity between the value of your portfolio and the changes in the market. It may seem simple, but KISS always prevails.