Sometimes, what you don’t know can kill you. Yes, even in the relatively controlled world of ETF investing!
ETF traders utilize a handful of investing strategies depending on their goals. Some are typical buy-and-hold investors that periodically rebalance, others dollar cost average into positions, and still others trade on technical signals, going long or short depending on the broader trend.
But some investors—generally those with retirement accounts—are not allowed to sell short. So from time to time, these people ask whether they can use an inverse S&P proxy like the ProShares Short S&P 500 (SH) to capture gains in a downtrend (ProShares offers a variety of inverse and leveraged funds which can be useful in limited circumstances, more on that later).
Using an inverse fund seems like an effective ETF investing strategy on the surface, but it hides a risk unique to leveraged and inverse funds: beta slippage.
How Does Beta Slippage Sabotage ETF Investing?
Investing in an inverse ETF like SH will do very well (gain value) when the market goes straight down. (And of course it will lose money just as readily if the market goes straight up.) But markets rarely go straight up or down. And even more rare would be to actually know in advance when the market will go straight down. We simply don’t know that much.
The best we can know is the probability that an uptrend or downtrend will continue. And even when our probability proves correct, most of the time the market will move in some kind of zig-zag or on-and-off pattern. And those zig-zag fluctuations work against the inverse ETF.
Here’s why. Because tracker ETFs seek to replicate their underlying indexes, the underlying stock portfolios (stocks held in the ETFs) are rebalanced daily. And the compounded returns of rebalancing cause a little erosion when the market fluctuates.
Consider a $10,000 investment in an inverse S&P ETF. Your investment controls $10,000 of the underlying index portfolio. That value will expand when the S&P goes down, and contract when the S&P goes up.
Suppose the index goes down by 1% one day and then bounces back to where it was the next day. That second day advance is slightly larger in percentage terms…approximately 1.01%. (100/99 difference from 1.00 is bigger than 99/100 difference from 1.00.)
So at the end of the first day, your original $10,000 is up 1% and is worth $10,100. Then the second day your ETF is down 1.01% of the $10,100, which is about $101. So the index is unchanged for the two-day span, and you’re down $1, holding only $9,999.
An actual short-sale would have returned your original $10,000 on the second day, but the inverse ETF will have slightly eroded your investment.
That kind of erosion goes on in inverse ETFs and (even more) in leveraged ETFs. The short-term up-and-down action (or down-and-up) nets a loss.
The same erosion effect grinds on as long as there is fluctuation—which is almost always—and the bigger the fluctuation (volatility), the steeper the erosion to your investment.
If the fluctuation is trending down (instead of flat like the example), the erosion is masked, and the trend gain can outweigh the volatility erosion. But the erosion continues as long as the fluctuation continues, eating away at your returns, even if you’re right about the market’s trend.
But that doesn’t mean inverse ETF investing is always bad!
Inverse ETFs are useful tools when there is reason to expect prompt decline in an index. For instance, they’re useful if you expect a bad economic report in the coming days, or if some technical market indications suggest imminent weakness. Such a bet will be right or wrong (depending on your insight and analysis), but will not suffer from debilitating erosion, because you’ll have the answer very shortly.
Investors who try to replicate portfolios or strategies that include short positions by substituting inverse ETFs for the short position may find that the inversion ETF becomes a submersion ETF. At the very least, it will reduce gains and increase losses.