Inverse exchange-traded funds try to delivery inverse returns of underlying indexes. To do that, they utilize various strategies that sometimes cause risks.
Compounding Risk
Compounding risk is one of the main types of risks affecting inverse ETFs. Inverse ETFs that are held for more than a day are affected by compounding returns. And since an inverse ETF has a single-day investment objective of offering investment results that are one times the inverse of its underlying index, the fund’s performance likely differs from its investment goals for longer periods greater than one day.
Investors who want to hold inverse ETFs for longer than one day must actively manage and rebalance their positions to mitigate compounding risks.
The effect of compounding returns becomes more obvious during times of high market turbulence. During periods of high volatility, the effects of compounding returns for periods longer than a single day to substantially vary from one times the inverse of the underlying index’s returns.
Derivative Securities
Many inverse ETFs offer exposure by using derivatives. Derivative securities are seen to be aggressive instruments and expose inverse ETFs to more risks.
Swaps are contracts in which one party exchanges cash flows of predetermined financial instrument for cash flows of a another party’s financial instrument for a particular period. Swaps on indexes and ETFs are made to follow the performance of their underlying indexes or securities.
The performance of the ETF may not perfectly track the opposite performance of the index and that’s because of the expense ratios and other factors like the negative effects of rolling futures contracts. Therefore, inverse ETFs that use swaps on ETFs typically carry greater correlation risk and may not attain high degrees of correlation with their underlying indexes compared to funds that only employ index swaps.
Correlation Risk
Correlation risks may be caused by a number of factors, including high fees, transaction costs, illiquidity, expenses, and investing techniques. Even though inverse ETFs try to provide a high degree of negative correlation to their underlying indexes, these ETFs usually rebalance their portfolios every day. This results to higher expenses and transaction costs incurred when adjusting the portfolio.
Further, reconstitution and index rebalancing events may cause inverse funds to be underexposed or overexposed to their benchmarks. These factors may lessen the inverse correlation between an inverse ETF and its underlying on or around the day of these events.
Futures contracts are derivatives traded on an exchange that have a predetermined delivery date of a specified quantity of a certain underlying security, or they may settle for cash on a predetermined date.
Short Sale Exposure Risk
Inverse ETFs may search short exposure through the use of derivative securities, such as swaps and futures contracts, which may cause these funds to be exposed to risks associated with short selling securities.
An increase in the overall level of volatility and a decrease in the level of liquidity of the underlying securities of short positions are the two biggest risks of short selling derivative securities. These risks may reduce short selling funds’ returns, meaning there will be losses.
