Reverse index funds

[jwblue]

http://www.investopedia.com/articles/mu ... z2JLRUloVo

Are these worthwhile as a hedge against a market fall?

[Johm221122]

Did you read conclusion
" conclusion Reverse market funds can reduce your exposure to the market without selling the securities you own and taking taxable gains. You may even win big when the markets tumble, or you could earn back prior market losses. However, these funds - especially those that use leverage to magnify potential returns - can lose money quickly in market rallies, and are best used to regulate portfolio risk.

Furthermore, the concept of betting against the market is tricky and mainly for market timers. After all, unless you believe the economy is in for a long-term decline and want to prepare for the worst, it might not make sense to own such a fund for the long term. Nevertheless, if you want to use a reverse market fund as insurance against losses, be sure to limit it to afraction of your portfolio."
John

[jwblue]

Assuming I believe this is a good hedge, what would be a good percentage to have in my portfolio?

[Johm221122]

Assuming I believe this is a good hedge, what would be a good percentage to have in my portfolio?

What are you hedging against? Taxable gains or long term market turmoil?If its long term market turmoil I'd say 0%. Why not add more fixed income?
john

[nisiprius]

First of all, jw, I suspect you have the wrong idea about what "hedging" can and cannot do. You can reshape the profile of the probabilities of various outcomes. And, if you are a gambler, you can use hedging to create the Wall Street equivalent of the "proposition bet." As a long-term investor, there's no way to magically cancel out the risk and be left only with the reward. When you cancel out the risk you cancel out the reward, too, and are left only with (high expenses).

These ETFs are for people making gambles on single-day market moves. You don't even need to read the darned prospectus, just look at the silly fund descriptions. They practically spell it out. ProShares UltraShort S&P 500
The boldface is theirs, not mine.

This Short ProShares ETF seeks a return that is -2x the return of an index or other benchmark (target) for a single day, as measured from one NAV calculation to the next. Due to the compounding of daily returns, ProShares' returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. These effects may be more pronounced in funds with larger or inverse multiples and in funds with volatile benchmarks. Investors should monitor their holdings consistent with their strategies, as frequently as daily. For more on correlation, leverage and other risks, please read the prospectus.

Consider this period of time over which an S&P 500 index investor, starting with $10,000, ended up with $9,639, i.e. a small loss of $361. So, the -2X ETF should have resulted in a small gain of about $722, right? Wrong.

While the S&P 500 fund was losing $361, the UltraShort S&P fund LOST over $5,000.

These funds have a huge degree of "volatility drag" created by the daily rebalancing. Notice how, yes, they follow the wiggles in the opposite direction but notice how, superimposed on that, is a steady drag down, down, down.

Is it possible to make money by timing the market properly in this ETF? Sure, but the chart above should convince you that the only way to do it is by successfully gambling on short-term movements, not on even medium-term holding.

These funds are the subject of a FINRA alert (FINRA-ese for "warning"):Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors

The SEC staff and FINRA are issuing this Alert because we believe individual investors may be confused about the performance objectives of leveraged and inverse exchange-traded funds (ETFs). Leveraged and inverse ETFs typically are designed to achieve their stated performance objectives on a daily basis. Some investors might invest in these ETFs with the expectation that the ETFs may meet their stated daily performance objectives over the long term as well. Investors should be aware that performance of these ETFs over a period longer than one day can differ significantly from their stated daily performance objectives.

[SSSS]

Assuming I believe this is a good hedge, what would be a good percentage to have in my portfolio?

I don't think you should invest in anything you don't understand.

It makes no sense to be both long & short on the same market (that's the same as not investing at all, but much more expensive), with the possible exception of esoteric tax situations.

[jwblue]

Assuming I believe this is a good hedge, what would be a good percentage to have in my portfolio?

What are you hedging against? Taxable gains or long term market turmoil?If its long term market turmoil I'd say 0%. Why not add more fixed income?
john

This makes sense.

[rkhusky]

I can see using the funds as a short-term hedge. Consider this example: It is the end of November and you want to sell a significant portion of equities in your taxable account, but that would bump you up into the next tax bracket (or perhaps there is some issue with short vs. long term gains). So, you want to delay selling them until January. But you are fearful of the market dropping in December (for whatever reason). So, you buy this reverse-index fund, say equal to 25% of the amount that you originally were planning to sell. Then sell in January. Not that I would follow this strategy, but I can see why someone might do so.

[ftobin]

I can see using the funds as a short-term hedge. Consider this example: It is the end of November and you want to sell a significant portion of equities in your taxable account, but that would bump you up into the next tax bracket (or perhaps there is some issue with short vs. long term gains). So, you want to delay selling them until January. But you are fearful of the market dropping in December (for whatever reason). So, you buy this reverse-index fund, say equal to 25% of the amount that you originally were planning to sell. Then sell in January. Not that I would follow this strategy, but I can see why someone might do so.

I think buying a put would be more cost efficient.

[Phineas J. Whoopee]

I can see using the funds as a short-term hedge. Consider this example: It is the end of November and you want to sell a significant portion of equities in your taxable account, but that would bump you up into the next tax bracket (or perhaps there is some issue with short vs. long term gains). So, you want to delay selling them until January. But you are fearful of the market dropping in December (for whatever reason). So, you buy this reverse-index fund, say equal to 25% of the amount that you originally were planning to sell. Then sell in January. Not that I would follow this strategy, but I can see why someone might do so.

[Emphasis added]

There's an extremely good reason not to do so. They invest only for the day. They sell short (or its equivalent with derivatives) at market open and buy at market close. The next day they do it again. The fund is not short the same portfolio each day. The compounding period is only a day.

See this Morningstar article from 2009 for the best explanation I've come across.
http://news.morningstar.com/articlenet/article.aspx?id=271892

Shorting on your own would be better than using an inverse fund, and buying a put option for the example rkhusky suggested probably even more so, unless you are an intra-day trader using a <1 day trading strategy, and still it's only perhaps. If that describes you, maybe posting on this forum is not the most productive use of your time.

PJW

[SSSS]

"Time decay" on leveraged and inverse ETFs is an interesting phenomenon. Over time, the price on any leveraged, inverse, or inverse-leverage ETF should trend towards zero, so they have to do reverse splits on a fairly regular basis to keep the share price from dropping unreasonably low. Apparently there are people making a small amount of low-risk money by shorting both a 3X long ETF and its corresponding 3X short equivalent. If rebalanced daily (or even more often) to maintain a 50/50 split, the market gains and losses roughly cancel each other out, but they're both subject to time decay, and since the investor shorted both of them, the time decay translates into steady, low-volatility gains.

Disclaimer: there are almost certainly risk and caveats to this, and it's not something I would consider doing. But when I encountered someone doing it, it at least sounded interesting from a theoretical perspective.

[grabiner]

"Time decay" on leveraged and inverse ETFs is an interesting phenomenon. Over time, the price on any leveraged, inverse, or inverse-leverage ETF should trend towards zero, so they have to do reverse splits on a fairly regular basis to keep the share price from dropping unreasonably low. Apparently there are people making a small amount of low-risk money by shorting both a 3X long ETF and its corresponding 3X short equivalent. If rebalanced daily (or even more often) to maintain a 50/50 split, the market gains and losses roughly cancel each other out, but they're both subject to time decay, and since the investor shorted both of them, the time decay translates into steady, low-volatility gains.

This shouldn't work because the rebalancing eliminates the time-decay; if it works at all, it is because shorting the ETFs causes you to gain the funds' expenses and transaction costs rather than losing them.

Ignoring expenses, a 3X long fund will gain 3X as much as the market each day, and a 3X short fund will lose 3X as much. Thus, if you are short $500 in the long fund and $500 in the short fund, you have a -$1000 portfolio. Now, if the market rises 2%, you will be short $530 in the long fund and short $470 in the short fund, so you gained nothing for the day if you rebalance to a neutral position.

If both funds lose one cent a day to expenses and trading costs, then you gain that one cent a day, which is $2.50 a year for a 2.5% return if the market is open 250 days during the year. You'll probably lose more than that 2.5% to spreads even if you trade commission-free.

If you short both funds and don't rebalance, the expected loss of both funds turns into an expected gain, but there is a big risk of a bull or bear market which will give you a huge loss.

[Joe S.]

Assuming I believe this is a good hedge, what would be a good percentage to have in my portfolio?

If you have 50% of your portfolio in an S&P 500 fund and 50% in a reverse S&P500 fund, you will have next to no volatility. However, your portfolio will slowly drop in value due to expenses. You would do better off putting 100% of your money in a bank account. There is really no good reason to put a reverse fund in your portfolio unless you are a bear.

[Phineas J. Whoopee]

Assuming I believe this is a good hedge, what would be a good percentage to have in my portfolio?

If you have 50% of your portfolio in an S&P 500 fund and 50% in a reverse S&P500 fund, you will have next to no volatility. However, your portfolio will slowly drop in value due to expenses. You would do better off putting 100% of your money in a bank account. There is really no good reason to put a reverse fund in your portfolio unless you are a bear.

Hi Joe,

Not even then, unless you're a bear for a period of time less than a day.

See the link I posted above. These funds do not work like one might intuitively think they do. They are not the contrapositive of long index funds, which stay invested.

http://en.wikipedia.org/wiki/Contraposition

Everyone already knows not to invest in anything they don't fully understand. The problem in this case is it seems as if we should understand, but that seeming feeling is incorrect.

Or to put it another way:
Everybody go around! Do not land at this airport! Everybody go around!

Yes, I chose my words carefully to be that emphatic.

PJW

[ourbrooks]

Apart from the potential problems of hedging, it's worth considering the actual results. Vanguard has a fund, the Market Neutral fund, whose "goal is to “neutralize,” or limit, the effect of stock market movement on returns". It "uses long- and short-selling strategies."

It has the lowest 10 year returns of any fund that Vanguard offers. Even tax exempt money market funds outperform it.

Vanguard presumably hires the world's best experts at these kinds of strategies. If that's the best they can do, what are the odds of success of any kind of hedging strategy I follow on my own?

[investor]

sorry...wrong thread