Last month I published an article titled Complex and Leveraged Exchange-Traded Funds. I discussed the goals and risks associated with many of these products. One of the topics examined was Inverse Exchange-Traded Funds. Here is a brief review:
Inverse ETFs use derivatives to bet against the direction of financial markets. These are known as short or bear ETFs and will make money if markets decline in value. They will lose money, however, if markets move against the bet. Covered call writers who have a bearish market outlook may find these funds useful.
I highlighted the next to last sentence because we find ourselves in a market that has been appreciating and showing strength due to positive economic news. While I remain cautiously bullish on the overall market many sophisticated covered call writers can benefit from the use of inverse ETFs in bearish market environments so a discussion is useful. Over the long haul, shorting the market is NOT a sound strategy.
Advantages of Inverse ETFs over short selling:
- Retail investors can use these products to short the market without being required to achieve shorting privileges which usually will not be granted to retail investors
- There are no margin requirements as there are with traditional shorting
- The loss potential for shorting is unlimited (the underlying can appreciate exponentially) but limited to the initial investment for Inverse ETFs
- Costs associated with short-selling are avoided
- Some funds include professional management which will assist less experienced investors
Disadvantages of Inverse ETFs over short selling:
- ETF share prices may not be exactly correlated to the underlying benchmark which may result is lower-than-anticipated returns
- As a general disadvantage we must re-tool our thinking to make decisions when to enter and exit our positions as we have been trained to look for positive market movers
Inverse ETFs (non-leveraged) that follow closely watched indexes:
- Inverse ETFs- Market Indexes
Recent short and long-term performance of Inverse ETFs:
Since the market historically appreciates in value in the long run, this is a short-term strategy that must be monitored carefully. Let’s first view a 1-month comparison chart of the four selected Inverse Funds compared to the S&P 500 as of 6-2011:
- 1-month chart of Inverse ETFs vs. S&P 500
Now let’s compare to a recent chart as of 1-24-13:
- 1-year chart of Inverse ETFs vs. S&P 500
These two charts demonstrate how both beneficial and risky Inverse ETFs can be.
Options chain for Inverse ETF RWM in a volatile market:
- RWM options chain
The 5-week return for the at-the-money $31 call is $70/$3100 = 2.3%
The use of Inverse ETFs by experienced covered call writers in the short-term can be a way of enhancing returns in bearish market conditions.
After a strong year in 2012 and a solid start to 2013 investors have recouped the $8 trillion they lost during the recession. Our economic recovery continues at a slow pace but continues nonetheless as good news outweighs bearish economic news:
- The unemployment rate increased from 7.8% to 7.9% in December BUT the number of non-farm payroll jobs increased and the revised job growth in 2012 was more impressive than originally estimated (from 155,000 to 196,000
- Private sector payrolls rose by 166,000 as government jobs fell by 9,000
- Personal income increased in November and December at the best pace since February according to the Commerce Department
- Personal savings rate climbed to 6.5%, the best in 4 years
- According to the Institute of Supply Management durable goods orders rose by 4.6% in December well above the 0.7% rise posted in November
- In the 4th quarter, GDP declined by an annualized rate of 0.1% but, also had a silver lining as consumer spending was strong, as was business investment in equipment and software. The contraction in GDP, many felt, was caused by the military spending cuts prior to the fiscal cliff outcome
- In 2012, the economy grew by 2.2%, better than the 1.8% rate in 2011
- Consumer confidence came in @ 58.6 well below the 64.0 expected. The return of the full payroll tax this year may have been a factor
- The ISM index for manufacturing activity was at 53.1, well above the 50.5 anticipated
For the week, the S&P 500 was up 0.7% to 1513.
IBD: Confirmed uptrend
BCI: Moderately bullish favoring out-of-the-money strikes 3-to-2
We will continue to work hard to justify the support and confidence you have gifted to our team.
My best to all,
Alan ([email protected])