Over the past couple of months, the financial media has been focused on the downturn in the markets, and rightly so. The S&P 500 ended the year down 7% after being up almost 10% in the third week of September.
And that doesn’t tell the whole story. The stocks that were darlings for much of the past few years really took it on the chin. Take a look at some of the FANG stocks. Apple (AAPL) dropped more than 32% from its high, Netflix (NFLX) dropped more than 38%, and Facebook (FB) was down more than 40%. Nvidia (NVDA) ended the year down more than 54% from its high!
When you’re looking to potentially profit from a bear market, there are a few things you can do. Each option has its advantages and disadvantages.
- You can short a stock or an ETF, but to do that requires a margin account. This is most easily done in a non-qualified account, such as a cash account or trust account. It’s more difficult to do this in a qualified account like an IRA. It’s theoretically possible to do it in an IRA, but some firms might not allow it, and, at best, you’ll be limited to a trade that’s 100% cash covered, limiting your other investment options. Remember, if you short a stock, you’re also responsible for paying any dividend that stock pays out when it goes ex-dividend. That’s a cost many people forget about.
- You could always buy a put option on a stock or ETF or apply some other bearish option strategy, but options ultimately expire and the liquidity on many options is poor. This makes it difficult to stay bearish for a long period of time and it potentially limits the number of your investment options.
- You could sell futures contracts, but those require a lot of money and, because of the leverage in these contracts, it’s possible to experience huge losses in a short period of time.
- You could buy inverse ETFs. Inverse ETFs are bought and sold just like any other ETF, and they are available for most of the major U.S. indexes and many of the sectors.
While the markets spun into bear market territory, the inverse ETFs turned around and generated new Stock State Indicator (SSI) buy signals. But what are inverse ETFs (also called “geared ETFs”), how do they work, and what are the potential positives and negatives?
As you can guess from the name, an inverse ETF is an ETF that moves higher in price when the underlying index or sector that it tracks moves lower. When SPY, the ETF that tracks the S&P 500, was moving lower in December, ProShares Short S&P 500 ETF (SH), the inverse ETF for the S&P 500, was moving higher by almost the same amount.
SH triggered a new SSI Entry signal on Oct. 24. It climbed more than 18% through Dec. 24 before falling back as the markets rebounded after Christmas. It has traded in both the SSI Green and Yellow zones since.
We know that the SPY ETF is composed of all 505 stocks that make up the S&P 500. But the SH ETF can’t do that. The managers can’t just go out and short all 505 stocks. The fund attempts to achieve its goal of getting the daily return of the opposite of the S&P 500 through three major investments.
The first investment is a small amount in short futures contracts. That makes sense as a way to gain when the markets are going down.
The second investment is in private contracts called “swaps.” Swaps are very simply private contracts between two parties. In this case, the swaps are between the ETF and large investment banks around the world. The contracts are set up so that if the markets go down, the swaps increase in value for the ETF. If the markets go up, the swaps decrease in value for the ETF.
The SH ETF has swaps contracts with Goldman Sachs, Citibank, Credit Suisse, and six other large well-known investment banks.
The third major investment might surprise most people. The ETF is actually invested in a series of short-term U.S. Treasury Bills. This is like having cash on hand in case the value of the other two major investments goes against the ETF. And because of rising short-term interest rates, SH actually pays a small quarterly dividend. As of Jan. 3, the dividend yield was a little over 1%.
As mentioned, when you short a stock, you’re responsible for paying the dividend when the stock goes ex-dividend. But with some of the inverse ETFs, you can actually get a small dividend yield.
The ETF sponsors usually have good websites that explain the composition of the individual funds. Here’s the link for the SH ETF.
The biggest positive with inverse ETFs is that they’re bought and sold just like any other ETF or stock. You buy and sell them during market hours. They can be held in any type of account, including IRAs.
But a discussion of inverse ETFs wouldn’t be complete without discussing the big negative that most people don’t know about. The goal of an inverse ETF (and leveraged ETFs) is to achieve the daily gain or loss of the underlying index. Because of positive or negative compounding, it’s possible to not achieve this goal over a long period of time.
Before investing a penny in these types of ETFs, you should read the disclaimers. Here’s the disclaimer on the ProShares website: Considerations for Geared Investing.
Take a look at the current SSI status of five different inverse ETFs that represent the major U.S. indices. These are as of market close on Jan. 4.
You’ll notice that all of the five ETFs are in the SSI Yellow Zone, but this is a little misleading. RWM just recently triggered a new SSI Entry signal after almost three years of being in the SSI Red Zone. RWM is the inverse ETF for the Russell 2000. The ETF for the Russell 2000, IWM, triggered an SSI Stop signal in late October of last year. Because of the imperfect nature of the inverse ETFs, IWM was in the SSI Red Zone for almost three months before RWM moved into the SSI Green Zone.
We’ll take a closer look at inverse ETFs during our educational webinar on Wednesday, Jan. 16 at 1 pm. ET. Click here to register for this presentation.
Cheers,
Tom Meyer
Research and Educational Specialist
