Inverse ETFs can offer a surprise return

Posted on: August 18, 2010 in: Uncategorized with 0 comments

First, my apologies: It’s been a long time since my last post back in early June. I was busy moving archerETF over to Bellwether (click here if you missed the note). After that, I have no excuse, other than that as with all virtuous action, it is easy to stop but difficult to resume.

Equity markets have been in turmoil since April. The S&P 500 was up 9% year-to-date, then down 8% YTD by early July followed by a 10% rally that brought us back to about even for the year. The rocky ride could continue into the autumn.

Many investors are opting for safety with government bonds. The yield on the US 10 Year Treasury Note has dropped to about 2.6% from about 4% in early April. The last time it was this low and heading lower was back in November 2008. Other investors are looking for securities that will actively benefit from a near-term drop in the S&P. I’ll take a closer look at one of these: ProShares Short S&P500 (Ticker SH).

The SH is a 1:1 short of the S&P 500. If the S&P goes down $1, SH should go up $1. However, as the saying goes, “There’s many a slip twixt cup and lip.” The SH uses derivatives, just like other ETFs that offer short or leveraged (or both) exposure. No problem, except that derivatives are a step removed from the actual investable entity and that means more slips between the return you actually get and what you expect to get.

I measured the size and number of these slips over the last four years. As expected, the longer the holding period, the more and bigger the slips. But there was a surprise. Had you bought the SH and sold within two weeks, your return was almost always (97.8% of the time) within an Acceptable Range (I’ve assumed plus or minus 1.5 percentage points) of the inverse of the S&P 500 return for the same period. The slips were few and not too large. The same if you’d sold after a month: about 92.9% of the returns were in the Acceptable Range.

It’s when you held the SH for even longer that things got interesting. Had you bought and held the SH for six months, the number of returns within the Acceptable Range fell to 34% but half the returns were at least 1.5 percentage points in your favour – either much higher or down much less than expected. Hold the SH for a year and the number of returns within the acceptable range was only 17% but two-thirds were at least 1.5 percentage points better than expected while about a quarter of the time, the SH return was worse than expected.

Here’s a table summarizing the results:

.
1 Day
2 Weeks
1 Months
6 Months
1 Year
>1.5pp Better
0.2%
0.5%
2.3%
53.2%
63.4%
Acceptable Range
99.7%
97.8%
92.9%
24.4%
10.7%
>1.5pp Worse
0.1%
1.7%
4.8%
22.4%
25.9%

The SH outperformed when the S&P fell sharply and vice versa, underperformed during strong rallies. In the six months to 20 Nov 2008, with the S&P down 45%, the SH was up 64% or 19 percentage points better than expected. On 7 Apr 2009, the market had rallied nearly 20% from its March low. The six-month return for the market was still -17% though and the SH should have been +17%. Instead, it was up only 3.8%, 13 percentage points less than it should have been.

Conclusion:

Buying the SH is a decent method for getting pretty near the inverse of the S&P 500 return provided you hold it for less than a month. The longer you hold it, the further your return will be from what you expect, though there is a fair chance that the slip will be in your favor. There is another ETF, the Proshares Ultrashort S&P 500, that aims to provide double the inverse of the S&P 500 return. I’ll take a look at that next time. And I take requests. If you have an ETF or some other security you’d like me to take a closer look at, let me know.

All the best until then.

Vikash

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