A new way to profit from falling stocks

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The evolution of Australia’s exchange-traded fund (ETF) industry continues apace, with this week’s launch of the first so-called ‘inverse ETF’ – an ASX-listed fund that allows investors to profit from stock market declines.

Launched by innovative Australian ETF provider, BetaShares, Australia’s first inverse product tracks the S&P/ASX200 index. Aptly trading under the ASX code ‘BEAR’, the product takes an annual fee of up to 1.38% out of returns through each year.

As BetaShare’s marketing material indicates, it’s investment objective is to “generate returns that are negatively correlated to the returns of the Australian share market.”

It will do this by investing most of the funds it receives in cash, but using a proportion to sell futures against the S&P/ASX200 index such that an overall net negative exposure of between 90 to 110% of the market is achieved.

Note, BEAR is not an ETF in the strict sense. It is instead an actively managed fund, but with a fairly simple quantitative strategy of maintaining close to 100% negative exposure to the market. It’s effectively an indexed bear fund.

BEAR is also not leveraged – its returns are expected to match that of the market, albeit in the opposite direction.

Designed in this way, it is anticipated BEAR will avoid some of the problems experienced in the US with traditional structured inverse and leveraged ETFs.

Offshore irritants

In America, most inverse ETFs are designed to match the inverse of daily percentage movements in the market – and in this regard, the ETFs are rebalanced at the end of each day so as to re-establish their 100% negative market exposure.

This results, however, in an erosion of their value over time due to market volatility. History shows that holding an inverse US ETF over the long-term often produces results that are far different than the inverse of the market return as they only promise to return the inverse of day-to-day moves in an index, not the inverse of the market’s long-term returns.

For example, if the market rises by 10% one day and falls by 10% the next, it will be down 1% over two days. It just so happens a traditional unleveraged inverse ETF would also be down 1% over this period – when an unwary investor might have expected the ETF to be up 1%.

Extending this example, if the market then rose by 10% the following day, the market would be up 8.9% after three days, whereas the inverse ETF would be down a larger 10.9%.

As evident, due to the need for daily re-balancing, the inverse ETFs found in the US (and especially leveraged ETFs) result in great deviations in performance relative to underlying markets overtime compared with traditional short positions.

In the latter two cases, if you short the market to the value of $100, your percentage return will equal the inverse of the market return over time (less financing costs).

The BEAR

Unlike typical US inverse ETFs, BetaShares will not re-balance its position each day, but rather allow its negative exposure to vary between 90 and 110% of the market. The implication is that short-run rebalancing losses caused by day-to-day volatility should be reduced, but it still won’t avoid deviations in ETF performance relative to the inverse of the market over long time periods.

The other issue with the BEAR fund is that if investors want to use it to hedge their portfolio against market declines without selling any of their shares, they will still need to raise the cash to buy it. If they don’t have spare cash equal to the value of their portfolio, they’ll have to borrow it.

Shorting alternatives

Already in Australia, similar protection – without the same re-balancing problems – can be achieved by short-selling a market-linked leveraged contract for difference, known as a CFD (such as the S&P/ASX200 CFD, code IQ), which effectively involves short-selling the market index with a margin loan financed at the official cash rate plus a 1.5% margin.

That said, due to the high levels of leverage, CFD trading has its own complexities and risks, and is not as straightforward as simply buying and selling ETFs. This is why the BEAR fund will likely still prove quite attractive.

The bottom line

The BEAR fund is a useful new addition to the tool kit of Australian investors. It is best seen as either a short-term trading or hedging tool that allows traders and investors to bet on near-term market corrections. Due to the ‘tracking error’ problems noted above, however, it is not suited for taking longer-term bearish positions in the market.

Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Anyone should consider the appropriateness of the information in regards to their circumstances.

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