An inverse ETF is designed to move in the opposite direction of the benchmark it is tracking. It will increase in value when the underlying benchmark declines and vice versa. These funds can be useful as a hedging tool within the portfolio or opportunistically used to take advantage of the market declines.
The behavior of inverse ETF is similar to shorting futures but provide greater flexbility as position sizing can be managed to the last dollar. The disadvantge of hedging using index futures is the minimum position is a sinlge futures contract. For example an SPI Futures which tracks the ASX 200 index (ASX 200 list the largest 200 companies in Australia) is priced at $25 per point so if the ASX 200 index is at 5,000, the value each futures contract is $125,000 each.
Betashares Australian Equties Bear Fund (ASX Bear) is the only inverse exchange traded fund listed on the ASX. The ETF aim to generate a return that is negatively correlated with the ASX 200 index.
The opposite of ASX bear (double negative!) is the ASX 200 index fund which gives investors exposure to the ASX 200 index by creating a portfolio which mimics the index.
What is in the inverse index fund?
BetaShares Inverse ETF achieve the inverse correlation with ASX 200 through selling ASX 200 futures. Total ETF return is dependent on the movement in the futures during the holding period as well as the yield on the cash held in the fund.
Investors should be aware of risks using futures in gaining exposure to particular assets such as equity index futures, commodities and energy which introduces its own set of risk and costs such as basis risk and cost of rolling contracts to the next front month/quarter contract.
ASX Bear vs ASX 200
It is commonly known inverse ETF have tracking errors which result in the funds not correlating 1 to 1 to the benchmark. The daily change in the price of the ETF can be 0.9 to 1.1 of the benchmark which overtime can lead to the return of the Bear ETF to deviate materially from the market index.
Dividends from STW can explain a portion of the tracking error. The table below shows the return of ASX Bear vs ASX STW over a number of timeframe and it is interesting that as timeframe increases, the tracking error of the ETF increases.
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In a perfect world the difference between the inverse index fund and the market index fund should be zero.
Inverse ETF tracking error
Typically these ETFs are rebalanced daily and the error is compounded overtime prevent the fund perfectly move in the opposite direct of hte benchmark.
The rule of thumb is that these are good for short term trading but as time goes on the tracking error becomes material. It is important to note the compounding can have a positive or negative effect on returns when the investment is held longer timeframe.
In a market with a clear and consistent trend, the ETF can outperform the benchmark. In range-bound markets, an inverse ETF may significantly lag its benchmark.
Example of beta slippage
The up and down moves make it prey to “beta slippage” or “volatility decay.” Here’s how that works: Pretend you paid $1,000 for one share of a 1x inverse ETF based on a index that’s at 1,000. On day one, the index falls 10% and closes at 900. The value of the fund goes up 10% to $1,100. On day two, the index closes at 1,000, up 11.1%. Your share goes down the same percentage; because the fund rebalances daily, it goes from $1,100 to $9,780.
You can see that while the index ended exactly where it began, you are left worse off. With an understanding of such risks, active traders and experienced investors use inverse ETFs to capitalize on short-term market moves. For others, inverse ETFs are a way to avoid selling out of a position whose outlook is bullish in the long term but challenging in the near term.