This is not investment advice. The information provided is for educational and informational purposes only and does not constitute a recommendation to buy or sell any financial product.
Leveraged inverse ETFs are ETFs that aim to deliver a multiple of the opposite of the daily return of an underlying index. A 2× inverse ETF on the S&P 500 aims to produce a 2% gain on a day the index loses 1%, and a 2% loss on a day the index gains 1%. The daily reset applies, and the same compounding risks that apply to leveraged ETFs apply to leveraged inverse ETFs, with the added twist that the inverse relationship is hard to sustain over multiple days.
The risks of leveraged inverse ETFs are the same as the risks of leveraged ETFs, with two additional risks: the decay in a trending market and the tracking error in a volatile market. The product is designed for short-term hedging and tactical short positions, and the product is not designed for a long-term short position on the index.
The compounding risk
The compounding risk is the most significant risk of a leveraged inverse ETF. The daily reset means that the product's return over a multi-day period is not the simple multiple of the index's return. In a market that goes down 1% for three consecutive days, a 2× inverse ETF gains 2% per day, and the net gain over three days is 6.12% (not the simple 6%). In a market that goes up 1% for three consecutive days, the 2× inverse ETF loses 2% per day, and the net loss over three days is -5.88% (not -6%).
The difference between the simple return and the compounding return is small over a few days and large over many days. In a trending market (up or down), the compounding works for or against the product. In a choppy market, the compounding works against the product, because the product loses value from the daily reset even when the index is flat.
The gap risk
The gap risk on a leveraged inverse ETF is the same as the gap risk on a regular leveraged ETF. The ETF is priced at the close, and the gap at the next open is reflected in the ETF's price. A 3% gap up on the index produces a 6% loss on a 2× inverse ETF and a 9% loss on a 3× inverse ETF.
The gap risk is most acute when the trader is using the leveraged inverse ETF as a hedge against a long portfolio. If the market gaps up at the open, the long portfolio gains (which hedges the inverse ETF's loss), and the combined position is protected. If the trader is holding the leveraged inverse ETF as a standalone short position, the gap loss is a real cost.
The tracking error
The tracking error is the difference between the product's return and the expected multiple of the index's return. The tracking error is produced by the ETF's management costs, the financing cost of the derivatives, and the ETF's rebalancing inefficiency. The tracking error is usually small for a major index ETF (0.1-0.5% per year) and larger for a niche index ETF (0.5-2% per year).
The tracking error compounds over time, and the trader who holds the product for more than a few days should expect a return that is below the multiple times the index's return. The tracking error is the reason that long-term holders of leveraged inverse ETFs consistently underperform the expected return.
The trending market risk
The trending market risk is specific to leveraged inverse ETFs. In a market that is trending up (a bull market), the leveraged inverse ETF is losing value every day, and the compounding amplifies the loss. A 2× inverse ETF in a market that goes up 1% per month for a year produces a loss of approximately 20-25%, which is larger than the -12% expected from the simple multiple.
The trader who is using a leveraged inverse ETF as a long-term short position in a trending market is fighting both the index trend and the compounding. The trader should use a different instrument for a long-term short position (a put option, a short ETF without leverage, or a short futures position).
When to use a leveraged inverse ETF
The only safe use is as a short-term hedge for a portfolio position. The trader who holds a long portfolio and expects a short-term drawdown (a Fed meeting, an earnings season, a known event) can use the leveraged inverse ETF as a hedge for a few days. The hedge is closed after the drawdown risk passes, and the cost of the hedge is the ETF's daily carry.
The product is not useful as a standalone short position for more than a few days. The compounding, the gap risk, and the tracking error all erode the return, and the trader is better off using a standard inverse ETF, a put option, or a short futures position.
Related resources
Where to start
If you are evaluating a leveraged inverse ETF, the most useful features to check are the leverage ratio, the expense ratio, the tracking error history, and the index's volatility. Our broker comparison lists the ETF products available at each broker, which together tell you what the cost and the risk look like before you buy.