During the selloff at the end of 2018, I heard from some readers who asked if it was 2008 all over again. It’s clear that even though the Financial Crisis is 10 years behind us, many investors still feel an uneasy knot in their stomachs when it comes to the stock market.

It’s hard to blame them.

Especially for retirees with a good chunk of their savings tied up in stocks, another market collapse would be a disaster.

There are no guarantees when it comes to investing. No matter how much research you do beforehand, anytime you invest in a stock, you are taking a risk that you could lose money. Still you do it because more often than not, quality stocks rise in value over time.

Generally, when the economy starts to show signs of slowing down, it makes sense to adjust your portfolio to be a little more defensive.

You should carefully think about what investments to use for protection, though. Sometimes, an investment that seems like a no-brainer as a hedge may not be as simple as it may appear.

Take inverse exchange-traded funds (ETFs), for example.

Opposite of The Benchmark

Inverse ETFs are structured to return the opposite performance of a specific benchmark on a day-to-day basis: a -1% day for the benchmark should result in a +1% day for the inverse ETF, and +1% for the benchmark would mean -1% for the inverse ETF.

One of the most popular inverse ETFs today is the ProShares Short S&P 500 (SH), which tracks the large-cap index S&P 500. As the fund’s mission statement states: SH “seeks a return that is -1x the return of its underlying benchmark (target) for a single day, as measured from one NAV calculation to the next.”

Since SH is designed to go up when the S&P 500 market index goes down, you would think that it would make a perfect hedge.

But in reality it’s not so straight forward.

When Inverse ETFs Work Best

In certain circumstances, it does make sense to purchase SH rather than, say, directly shorting the S&P 500.

If you are trading in an Individual Retirement Account (IRA), you won’t be able to short sell. Also, short selling carries the theoretical potential for unlimited loss, whereas if you bought SH, your maximum loss would be your cost basis.

Inverse ETFs work best when the market consistently marches downward. For example, if the S&P 500 falls five days in a row, SH will do well for you. Consequently, it’s important to detect warning signs in the market and time your moves accordingly.

Volatility Hurts Inverse ETF

However, when volatility is high and the benchmark swings up and down, SH’s return will tend to deviate from its target in a negative way.

Take a moment to study this table:

The table shows SH and SPDR S&P 500 ETF (SPY)—an ETF that seeks to track the S&P 500 on a 1:1 basis—over an eight-day period.

As a normal ETF, SPY tracked the S&P 500 perfectly after the eight-day period. But for SH, although it tracked S&P 500 exactly as it should day to day, at the end its cumulative return was lower than what you would expect.

Since the S&P 500 fell 1.08% over this period, you might expect SH to return +1.08%. In fact, the return was just 0.92%.

Another Illustration

It’s hard to explain in words so let’s use a more extreme example to illustrate.

Let’s say you have an asset worth $100, and you have an inverse ETF tracking that asset also valued at $100. The asset first falls from $100 to $80 (-20%) on Day 1, but then climbs from $80 back to $100 on Day 2 (+25%).

For the inverse ETF, it would gain 20% on Day 1 from $100 to $120. On Day 2 it would fall 25% from $120 to $90. Even though the inverse ETF tracked the asset each day in percentage terms exactly as it should, at the end it is worth $90, a loss of 10%.

Percentage vs The Dollar

The key is that an inverse ETF is designed to track the underlying asset in percentage terms, not in dollars. This matters a great deal.

In the table directly above, because both the asset and inverse ETF started at $100, a 20% change in Day 1 meant a $20 swing for both. But by Day 2, because the asset and inverse ETF had different starting values, a 25% change is a $20 upswing for the asset but a $30 downswing for the inverse ETF. Again, both changed 25% but the dollar change is different.

You may wonder what would happen if the asset first rallied then fell? Check this out:

You’d still get a raw deal. Instead of a +10% return out of the inverse ETF, you only broke even though the asset fell 10%. After a 20% fall, you needed a 25% gain just to get back to your starting point.

Points to Remember

If all this sounds confusing, don’t worry. The most important thing to remember is that volatility will likely reduce an inverse ETF’s return compared to its target goal.

In addition, because inverse ETFs need to be actively managed, their expense ratios will be higher than those of a regular ETF. SH’s expense ratio is 0.89%, compared to 0.09% for SPY. Over time, this will eat into your return.

For these reasons, inverse ETFs like SH tends to work better when held for a short period of time. The longer you hold the inverse ETF, the more likely you will encounter volatility, which as shown above will work against you.

Leveraged inverse ETFs, which seek to return 2x or 3x the underlying benchmark’s return, have the same problems, only worse.

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