Commodity funds have brought the individual investor access to both hard and soft commodities. Many of these products were not previously available for portfolio allocations on such a broad scale and are leading to changes in the way they are applied in the development of both large and small portfolios.
Like leveraged products, inverse ETFs use gearing to provide their expected returns. Gearing is a means of measuring financial leverage, specifically it is the ratio of leverage to equity. In the case of a normal inverse ETF, the gearing ratio will be 1. With a leveraged short fund the gearing might be 2 or even 3 times. There are many more leveraged short products than products that provide inverse exposure. The inverse funds exhibit the same traits as the leveraged funds in terms of compounding and rebalancing, but those effects are muted because of the low gearing in the products. The effects are also dependent on volatility and will increase and decrease proportionally.
Essentially, like leveraged products, these funds hold swaps to achieve their exposure. A short S&P 500 fund would hold a swap, paying the returns of the index to the counterparty. If the index trades up on any given day, the ETF would have to pay returns on the index to the counterparty, causing the value of the ETF to decrease. If the index trades down, the ETF would be receiving the return of the index, thus driving its net asset value (NAV) higher on the day.
In order to achieve the daily return of the index on a rolling basis, the funds will reset their holdings daily in the same manner as the leveraged products. Inverse funds bring an important tool to the investing community in the form of long negative exposure.
You can trade and access liquidity using inverse ETFs in the same manner as any other ETF. If you are a buyer of the inverse S&P fund, for example, you can buy it in the market electronically or you can go to a liquidity provider for an NAV-based execution or for them to provide you with a large-block market. In this scenario, the liquidity provider (LP) would be shorting the inverse S&P fund to you, so they effectively would have long exposure to the S&P 500. In order to hedge itself, the LP would have to sell some form of correlating exposure, either the basket, futures, or another derivative to offset the long exposure. This is opposite the scenario of the LP selling a long-based ETF to a client.
Some important factors about the inverse ETF should be understood when trading them. They are one way to achieve downside market protection in accounts that typically cannot achieve that type of access, such as IRAs. You can buy a product that will increase in value as the market declines. This opens up an entirely new way to position your portfolio. Formerly, long-only investors had the opportunity to have long market exposure or cash; now they can take advantage of, or protect against, expected down moves in the market. This could have a profound effect on the way people manage their investment portfolios in the future.
Another characteristic of inverse products is the changes in their exposure. For those who were able to short listed products previously, these products offer a way to short the market without the risk of unlimited losses. When you short a stock or ETF in the market, you are exposed to that position going potentially infinitely higher. Your portfolio could suffer devastating losses. When using an inverse ETF, the losses are limited to the amount that you invested into the position. When you are correct in your positioning, however—when you are using an inverse ETF and your underlying exposure is going down—your exposure to that position is also increasing. As the market is moving lower, your ETF NAV should be moving higher, increasing your notional exposure to the position, if the cumulative direction is correct. This is the opposite effect of a typical short position in which your notional exposure decreases as the market moves lower.
Although inverse ETFs do provide a very important and functional tool, how they are used is critical to investment performance. Distinguishing investment goals and time horizons and understanding what potential market activity can do to the performance of your portfolio is extremely important.