There are many benefits to investing in exchange traded funds (ETFs) including how easy they are to access. But their accessibility is double-edged, with some investors lured in by much riskier products with poor track records like inverse ETFs.
In this article we discuss:
- What is an inverse ETF?
- What inverse ETFs are available on the ASX?
- Why are inverse ETFs becoming popular?
- Should you invest in an inverse ETF like BBOZ and BEAR?
What is an inverse ETF?
Inverse ETFs do the opposite of what the share market does. If the share market goes down, the value of the inverse ETF will go up (and vice versa). Investors use inverse ETFs to try ‘short’ the market, aiming to profit from the price going down.
Behind the scenes, these ETFs use derivatives (i.e. complicated investment contracts) to generate the opposite effect. These derivatives are generally expensive to manage which is one reason inverse ETFs attract very high fees.
Which inverse ETFs are available on the ASX?
There are four inverse ETFs available on the ASX providing exposure to the Australian and U.S. market. In this article, we focus on the two inverse ETFs tracking the Australian market.
BetaShares Australian Equities Bear (Hedge Fund) (ASX: BEAR)
The BEAR ETF has an investment objective to do the opposite of what the Australian share market does on a daily basis. If the Australian market goes down by 1%, the fund’s value will go up (before fees and expenses) by ~1%.
BetaShares Australian Strong Bear (Hedge Fund) (ASX: BBOZ)
The BBOZ ETF has a similar investment objective to BEAR, but does so with a magnified and leveraged effect (by 2 to 2.75 times). If the Australian market goes down by 1%, the fund’s value would go up (before fees and expenses) by ~2% to 2.75%. The fund’s magnification (i.e. gearing) is actively managed, which means it can vary between 2x to 2.75x each day.
What’s behind the recent trading surge of BBOZ and BEAR?
When COVID-19 hit earlier this year, some investors feared a continued market plunge and turned to inverse ETFs – either to protect their portfolios or speculate on further falls.
In March 2020, BBOZ was the most traded ETF in Australia, recording a monthly trading volume of nearly $2 billion (i.e. $83m was traded every day!). This phenomenal trading volume was driven by large institutions and day traders, and meant that BBOZ was even traded more than blue-chip stocks like Telstra.
Should you invest in BEAR or BBOZ?
Over the long term it’s pretty clear these products are awful. If you’d invested in BEAR and BBOZ back in 2015, you’d have lost 70% of your money. In the long term, these products are likely to lose you money because markets tend to rise.
If you’re going to use them, they should only be considered as short-term speculative trading products, due to three main reasons: high fees, daily rebalancing, and the folly of market timing.
Inverse ETFs and high fees
Fees eat into your returns, and inverse ETFs charge high fees, with BBOZ charging 1.38% per year and BEAR charging 1.48% per year. These fees don’t include the trading costs and spreads when you want to get in or out (which are five times the cost of an index ETF).
Inverse ETFs and daily rebalancing
An often overlooked issue with inverse ETFs is the daily rebalancing required inside the ETF and the negative impact this has on its price.
For example, BBOZ needs to adjust it’s leverage exposure each day if it falls outside the target range of 2x-2.75x. Index ETFs tend to rebalance much less frequently (e.g. quarterly or semi-annually). Adjusting the gearing level daily can lead to higher fees and transaction costs and makes returns much more volatile due to compounding risk.
Here’s an example:
|Date||ASX 200 Index Price||BBOZ ETF Share Price|
|11 March 2020||5725.87||12.60|
|12 March 2020||5304.63||14.75|
|13 March 2020||5539.30||13.65|
|16 March 2020||5002.02||15.49|
|17 March 2020||5293.41||13.97|
You’d expect that given the market fell 7.6% over these five trading days, your BBOZ ETF would be up by 2x 7.6% or 15.2%. But it’s not the case. Due to daily rebalancing and higher fees, the total return is only 10%. Not a bad return for a down market, but this example highlights the risks involved with inverse ETFs and that you don’t actually get double the return after costs and the daily compound impact.
Inverse ETFs and market timing
Inverse ETFs are also dangerous because market timing is almost impossible, even for the experts. If you own an inverse ETF during a market bounce, even if the bounce only lasts a few days, your initial returns will be quickly eroded. As markets have recovered since March, the price of inverse ETFs have fallen rapidly and their returns are now negative for 2020.
Other ways to protect your portfolio
Using inverse ETFs to protect against a falling market is not an effective long term strategy. The high costs and daily compounding mean that the price of inverse ETFs will fall significantly over time. By the time a market correction arrives, your inverse ETF will already be worth much less than when you bought it.
A much more effective approach to defend your portfolio is to own some defensive assets like government bonds and gold that can cushion market falls. Defensive assets like bonds and gold don’t tend to have high fees or fall in value over time like inverse ETFs. Yet they can still reduce the impact of market falls by up to 80%, as they did during the COVID crisis.