What is wrong with Inverse ETFs?

Double-edged swords cut both ways

August 2022. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Inverse ETFs come with significant risk disclosure
  • Analyzing the performance of these products justifies the warnings
  • There is a significant difference between performance of inverse ETFs & the inverse underlying indices

INTRODUCTION

In May 2022, Allianz, the large German insurance company, agreed to pay $6 billion in damages to investors and have its U.S. asset management arm plead guilty to criminal proceedings due to the collapse of a few investment funds. These were supposed to create alpha regardless of the market conditions, but lost $7 out of $11 billion under management during the COVID-19 crisis.

The case of Allianz highlights the risk of running an asset management company in the U.S., which has become riskier over time as the judicial system allows much larger payouts than in other jurisdictions when legal cases are won. Given this, the risk disclosures in the prospectuses of U.S. investment products keep on increasing in length. Somewhat ironically, the longer the prospectuses become, the less useful they are for investors as they are too time-consuming to read and require more legal acumen.

The risk disclosure also depends on the product and some are more upfront about the investment risks than others. One category that is very explicit about risks is inverse ETFs, which aim to provide the inverse performance of indices like the S&P 500. For example, the website of the ProShares’ Short S&P 500 ETF (SH) is dominated by a large section called “Important Considerations”, which is rather unusual as such risk warnings are typically found at the bottom in a relatively small font size. It seems inverse ETFs are especially risky.

In this research note, we will explore the peculiarities of inverse ETFs.

UNIVERSE OF INVERSE ETFs

We focus on inverse exchange-traded products and funds (ETPs & ETFs) traded in the U.S., which is a universe of close to a 100 products that cumulatively manages approximately $20 billion. Given that the total assets under management of ETFs in the U.S. is more than $7 trillion, it represents a small niche of the ETF market.

The universe of inverse ETFs covers various asset classes such as equities and fixed income, broad indices like the S&P 500,