Understanding Inverse ETFs - YouTube

Hey everyone, and welcome back to Option Alpha.

I’m Kirk, here again and we’re going to go over inverse ETFs on this particular video.

As we all know, ETFs are very popular and becoming more popular.

And as the development and issuance of regular ETFs, so have the issuance and development

of inverse ETFs have started to really ramp up.

And really, over last two or three years here, we have a lot of inverse ETFs that have started

to come out.

Not only that, but there’s also double-long, triple-long, triple-short, double-short, etcetera,

etcetera.

What I wanted to go through here is a simple example that shows you guys some of the risk

that are involved in some of these double and ultra-long and ultra-short ETFs.

Follow along with me, it’s going to be really easy, and then we’ll take a look at an actual

example to really prove and drive home the point here.

Inverse ETFs: Let’s use first a simple savings example just to get our bearings here.

Let’s say we’re going to save $100 at 10% per year.

After the first year as a simple math, we have $110 in our account or a $10 profit.

We made 10% on our initial $100.

Let’s say we kept that money in the bank and after two years we have $121.

Not another $10, but an actual $11 profit and that’s because we made an extra 10%

on our $10 profit which is an extra dollar which is why we have $11.

After year seven, you can see we’d have about $195 which actually turns out to be

about a 13.55% return.

Not exactly the 10% return that we had initially thought.

That would be simple interest, but we’re dealing with compound interest.

Let’s now put that $100 into three different funds.

We’ll call Fund A just the simple index fund and this could be anything from the SPY,

to the DIA, to the Qs, etcetera.

Fund B, let’s go into a double-long ETF, so a double-long or an ultra-long ETF.

And then in Fund C, what we’re going to do is we’re going to go into a double-inverse

ETF, so a double-short or an ultra-short.

Going over these, let’s assume that we get a 10% return today.

ETF funds are calculated on a daily basis, not a monthly or yearly basis, so let’s

say we get a 10% return today.

And simple math here, after day one, Fund A which is just the index is $110.

It started at $100 and it’s now at $110.

After day one, Fund B which is our double-long is going to be at $120, so we’re making

double what the daily return is.

The index return is 10% today.

We’re going to make 20%, twice that value.

This is really where the advantages to these come into play.

After day one, Fund C which is our double-short is going to lose 20%, so losing double what

the index made.

We’re going to be down $80 in that value for that portfolio.

Now, let’s move forward and let’s say that the next day, on day two, the index actually

returns -10%, so on average, giving about a 0% gain, so it gives back all the gains

from yesterday.

But now, the numbers start to look a little bit different.

Fund A is at 99%.

10% of the $110 value which we were last at is $11, so we’re actually going to give

back $11 if we lose 10% from there.

Now, the fund is going to be just below breaking even.

Fund B which is our double-long fund is going to give back 20% of our $120.

Remember it made 20% the first day, so we’re going to give back about $24 and be at $96,

so below par.

And Fund C was going to make 20% instead of losing 10%, 20% of $80 which is $16 and being

back at $96.

You can see if we repeat this process for about six months straight, 10% up days followed

by 10% down each day, Fund A which is our index would be at roughly 95.10% on average,

Fund B and C would both be at approximately $2.54.

You can see that both of these leveraged ETFs have lost nearly 97.5% of your investment.

Now, talk about a tracking error on the part of these ultra-fund brokerage houses, these

are supposed to track them 10% up, 10% down, double up, double down, but you can see that

if you actually do the math and work the numbers out that they actually start to lose money

over the long run.

Let’s actually take a look at a real example here on my screen.

We’re back here on my screen and all I’ve done here is go to ycharts which is a great

website, ycharts.com and typed in the QQQ which is the PowerShares.

It follows the NASDAQ.

It’s a NASDAQ ETF.

And what I’ve done here is I’ve actually put in the QID which is the ultra-short and

then the QLD which is the ultra-long of the Qs.

I’m just doing the same portfolio that we had assumed before, same thing, three different

portfolios, an index, an ultra-short, ultra-long, etcetera.

And I’ve put the returns on here for the last five years and you can see that the orange

is actually the index.

It is the Qs or the QQQ.

The blue here is the QID which is the ultra-short and then the red here is the QLD which is

the ultra-long of the Qs.

After all this time, after five years, you can see we obviously had a really, really

good return spike in the QID which is the ultra-short during the market crash of 2000-2009.

Absolutely, definitely really shows the advantages of having these in your portfolio if you are

going to use them for short-term hedging or for short-term directional plays that you’re

going to speculate on.

And you can see that as the markets were falling, these went up almost nearly 100% at one point.

But over the long run, you can see here that after five years that the index is still far

outperforming both of these leveraged ETFs.

And what’s funny here is that actually, it’s outperforming the QLD which is the

ultra-long ETF.

Now, wasn’t that funny?

The index is supposed to be up 28% over the last five years, but the QLD should be up

more than that, double what the index is up, but it's not.

And this is where that pricing differential comes in.

It’s adjusted on a daily basis.

This daily change in the markets have a negative impact over the long run.

And the longer this goes, the more the negative impact it’s going to have.

And you can see that the QID has already decayed tremendously.

It’s down about 77% over the last five years.

This really drives home the point.

And this is a live example.

This is data taken from tonight when I actually just went in here.

I just put in some data for November 2011, the last five years and ran the numbers for

returns.

It's really interesting.

As always, I want to point out these different kinds of risks.

I think a lot of people get confused when they start talking about inverse ETFs.

They really get excited about buying some of these inverse ETFs and then profiting whenever

the market drops, but that’s not really the case as we’ve seen here.

Use them wisely.

Know what the risks are.

As always, there is good and bad to both.

There is advantages and disadvantages to both.

I’m not saying one is better than the other, but this really drives home the point of the

pricing differential between these leveraged ETFs.