4 Reasons Why Inverse ETFs Are Broken & Here’s A Better Solution

There is a big problem on Wall Street that almost no one is talking about – Inverse products simply do not work as well as actively managed products. Right now, billions of dollars are invested in inverse products that are designed to hedge a portfolio and go up in value when the stock market falls. But, when you step back and analyze the data, many of these inverse funds do not work properly and they have many inherent flaws that exist (and can be prevented) in plain sight. Here are a few flaws for your consideration:

Flaw # 1: Tracking Error

The basic idea of an inverse product is that it goes up when the market goes down. The three most popular strategies are 1x, 2x, and 3x inverse products. Which means, they are designed to be inversely related to their benchmarks and go up 1x, 2x, or 3x their index when the index falls. For example, as of Wednesday, October, 21, 2020’s close, the S&P 500 is up +6.34% for the year but the 1x inverse ProShares Short S&P 500 ETF (Ticker: SH) is down -17.45% during that time! That’s the 1x product. The ProShares UltraShort S&P500 (SDS), which is a 2x inverse product, is down a whopping -39.10%. That’s with the S&P 500 up +6.34%. That said, the 1x product should be down 6-7% and the 2x product should be down 12-13%. Not, down -17% and down -39%, respectively.

Flaw # 2: Negative Math & Compounding Error:

There are many reasons why this happens year after year but the most common can be attributed to compounded error. Compounding error refers to something that I call negative math- which means the math is not 1 to 1 when something falls. For example, if something falls 50% it needs to go up 100% to get back to even. On the other hand, if it goes up 50% it only needs to fall 50% to go back to even. That’s why inverse products have such a difficult time getting back to even, let alone going up after steep down periods.

These are two fundamental problems with inverse products. Let’s look at the Russell 2000 which is down -3.88% in 2020 (during the same period). Meanwhile, the Direxion Small Cap Bear 3X inverse product (Ticker: TZA) plunged -60.49% during that period! How is that possible you might ask when the benchmark it “tracks” is only down 3.88%! The same is true for the Nasdaq 100 NDAQ , which is one of the strongest indices in 2020. Inveco’s QQQ etf, which tracks the Nasdaq 100, is up a very impressive +33.95% during that period. Meanwhile, the ProShares UltraPro Short QQQ (Ticker: SQQQ), which is a 3x short product is down -80.56%, which is closer, but still not 3x the QQQ’s return. I can go on and on but I trust the point is made, most inverse products simply do not work.

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Flaw #3 Very Short Hold Time: Only One Day

Another big flaw with inverse products is that they are designed to be held for only one day. If you read the fine print, they specifically tell investors that their products should not be held for more than one day. One day? That sounds great in theory but how many investors only hold a product for one day? Especially, one that is designed to hedge their portfolio? In fact, if you look at 13F filings, it shows most institutional investors hold these inverse products for a very long time and are not selling it at the end of each day. That opens to door for potential litigation and that has occurred in some cases recently where clients are suing their fiduciaries for holding these products for a long period of time when it specifically says don’t do that.

Flaw #4 Short Super Strong Leading Stocks

Another big flaw that most inverse products have (that can’t be avoided) is that they, by definition, have to be short the entire index – even the strongest leading stocks in the market. Why would anyone want to be short the strongest leading stocks in the market – especially, when we all know that leading stocks provide most of the gains for the index at any given time?

Better Solution: Actively Managed Products

I have found a better solution and that’s hedging your portfolio with actively managed products. The good news is that many actively managed products offer great downside protection, do not have to be short the super strong leading stocks in the market, can be held for long periods of time, and do not have the wild tracking error that inverse products have. That’s why savvy investors are shifting into products such as the Ranger Equity Bear ETF (Ticker: HDGE) as a great way to hedge their portfolios. For the most part, actively managed products, give you great downside protection when the market falls and do not offer the fundamental flaws mentioned above that exist in most inverse products.

Standard Disclosure: My firm provides, or has provided, research, and other services, to some of the firms mentioned in this article.

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