Quizmaster, Doug Hutchinson, presents his quiz for the month. Here, Doug teaches a lesson on antcipating inverse ETF returns.
Consider this Scenario:
Your friend Gary is feeling bearish on the stock market so he purchased $10,000 of an inverse ETF. The inverse ETF he purchased aims to return the opposite of the daily return of the S&P 500 (for example, if the S&P 500 goes down 1% on a given day, the inverse ETF should go up 1% on that day).
There are several reasons why an inverse ETF may not be exactly the inverse of the index on a given day (expense ratio of the ETF, tracking error, trading costs, etc.) but for the purposes of this example, assume that Gary’s inverse ETF returns exactly the inverse of the daily returns of the S&P 500.
In the five days after he purchased the ETF, the daily returns for the S&P 500 index were:
Day 1: +5%
Day 2: -2%
Day 3: +1%
Day 4: -2%
Day 5: -2%
The cumulative return for the S&P 500 over the 5-day period was -0.1866% {(1.05 x 0.98 x 1.01 x 0.98 x 0.98) -1} = -0.1866%.
Gary is excited because he believes that his inverse ETF must be up 0.1866% over the same time period. Gary is very surprised to learn that the value of his inverse ETF has actually gone down since he purchased it five days ago despite the fact that the cumulative returns of the S&P were negative over the past five days.
Why was Gary incorrect to assume that the returns of his inverse ETF must be positive over the same time period that the cumulative returns of the S&P were negative?
Solution:
The inverse ETF returned exactly the inverse of the index on that day only. Because of compounding, inverse ETF returns are not necessarily exactly the inverse of the index if the holding period is longer than one day. The compounding effect increases with higher volatility, greater leverage, and longer holding periods.
Gary’s daily returns over his 5-day holding period for his inverse ETF are:
Day 1: -5%
Day 2: +2%
Day 3: -1%
Day 4: +2%
Day 5: +2%
The cumulative return for his inverse ETF over the 5-day holding period was -0.1934% {(0.95 x 1.02 x 0.99 x 1.02 x 1.02)-1} = -0.1934%
Gary learned the hard way that an investor in an inverse ETF may correctly predict the direction of the market but still lose money. If your holding period in an inverse ETF is longer than a day, your returns might be much different than anticipated.
The Wealth Managers at WrapManager can provide expert advice on investing with ETFs. Give them a call at 1-800-541-7774 or contact us here to get in touch with an Investor Consultant today.
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This quiz is intended for informational and illustrative purposes only. This quiz is intended for informational and illustrative purposes only. This material is not intended to be relied on as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. The information and opinions contained in this material are derived from sources deemed reliable, are not all-inclusive and are not guaranteed as to accuracy.
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