January was a bumpy month for domestic equities as the S&P 500 declined by 3.5%. Perhaps the decline was influenced by the even larger decline in emerging markets, an earnings season that was viewed by some as disappointing or for no reason at all (markets don’t always have a reason for what they do).
As we’ve been discussing over the last few weeks, when markets show signs of trouble clients tend to get nervous and ask questions about how to protect their portfolios. One tool at advisor’s disposal are funds that sell short one way or another; inverse index funds or funds that sell short individual stocks.
ETF.com tracks 55 exchange traded products in this space with total assets greater than $7 billion. The vast majority of those assets are in inverse index funds which have the complication of the a daily reset which is the biggest point of understanding that clients will need to know about in order to decide whether or not to use this type of fund or some other short selling strategy.
Inverse index funds seek either 1x, 2x or 3x the inverse of the index they track on a daily basis. In the past these funds have drawn a lot of criticism because of the perception that they don’t do what they are supposed to. This led to more regulatory scrutiny and resulted in their use being restricted on many brokerage firm platforms.
Meeting the actual stated objective, a targeted result on a daily basis, requires repositioning toward the end of every trading day so that the following day the proper exposure is created for the following trading day.
Clients generally expected that if a broad index went down 10% over some period of time that a 1x inverse fund would go up 10% over that same period of time. When funds did not deliver this type of performance over periods greater than one day is when the perception problems started.
The reality is that they did what they were supposed to do but what they were supposed to do did not line up with investor perceptions. Inverse index funds seek to deliver an exposure today not over some longer period of time. If the S&P 500 goes down 1% today than a 2x inverse fund will go up 2% today and that has been reliable.
This has led some to conclude that these funds cannot meet their objective over longer periods of time but that isn’t quite right. The reality is that whether or not these funds meet the imprecise expectation of delivering 1x, 2x or 3x over longer periods of time depends on the combination of up and down days and the size of the moves in that time period which of course is unknowable.
The history of these funds is that sometimes they do “work” over longer periods of time and sometimes they have not and whenever the next bear market comes there is no way to know whether an inverse index fund will do what clients hope or not.
Advisors wishing to avoid this issue can consider funds offering short exposure that avoids the daily objective issue which we will cover in a future post.
This article was written by AdvisorShares ETF Strategist Roger Nusbaum.