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Understanding Inverse ETFs

Inverse exchange-traded funds (“ETFs”) and exchange-traded notes (“ETNs”), both flat and leveraged, have been the subject of a lot of debate these days.  I believe that a lot of the confusion and concern stems from a basic need for the industry as a whole to do a better job of educating the investing public about the rapidly evolving market of exchange-traded products.  For example, the inverse products themselves may or may not be appropriate for long term investors because of their daily valuation mechanism.  Inverse products essentially reset every day which is why buy-and-hold type investors are dismayed that the returns of the inverse ETFs and ETNs often vary significantly from what would be expected given the performance of the underlying index.   

Let’s look at ProShares Short S&P 500 ETF (Ticker: SH) as an example.

According to the ProShares website, SH seeks daily investment results, before fees and expenses, that correspond to the inverse (opposite) of the daily performance of the S&P500� Index.   According to Bloomberg, the S&P 500 index has a year-to-date price appreciation of 4.11% and SH has a year-to-date price appreciation of – 11.32% through July 17, 2009.  Not exactly, the mirror opposite of the return of the S&P 500 Index that a longer term investor might be expecting but that is not what the product is trying to achieve.  This difference gets further amplified for the 2 x (and 3x leveraged products now available from Direxion) leveraged inverse products.  However, a closer look at the underlying daily performances of the S&P 500 and SH over the course of the month of June shows that the product is performing relatively consistently with its stated objective.

Hence, for investors looking for a short-term (i.e. daily) hedge against a certain index, these short products may provide for an appropriate solution.  On the other hand, investors looking for a longer term hedge against a certain index may want to look beyond these inverse products and, perhaps as an example, consider shorting the actual long ETF for the respective index in question.  As I understand it, there is even talk that some product sponsors may be considering coming out with longer term inverse strategies in the future as well.  

All of this debate should serve as just another reminder to investors, and advisors for that matter, to fully educate themselves on the many nuances associated with the multitude of different investment strategies now available in the ETF marketplace before making an investment decision.

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