How bad are inverse exchange-traded funds (ETFs) at returning the inverse movements of the indexes they track? Frank Elston and Doug Choi tell us in a paper published in the Proceedings of the Academy of Accounting and Financial Studies (Volume 14, Number 1: 2009). It turns out out they can be so bad in replicating implied returns that Elston and Choi conclude investors would be better off in many instances shorting the long or double-long ETFs instead.
Inverse ETFs use swaps and futures; swaps predominate in inverse ETFs because of their flexibility (don’t require standard deposits or times to expiration). But swaps are purchased over the counter from banks such as Goldman Sachs and Morgan Stanley — and thus come with counterparty risk. Many swaps are not subject to mark-to-market accounting and margin maintenance requirements.

Probably the most serious drawback of inverse ETFs is the significant tracking error due to the constant-leverage trap (arising from the inverse ETF’s objective of returning the opposite of the index on a daily basis). The table at the end of this post shows a representative cross section of tracking errors calculated by Elston and Choi for 2008.

In the table, (DOG), an inverse ETF tracking the Dow Jones Industrial Average (DJIA), underperformed its implied return by over 3%. (DXD), a double-inverse ETF for the DJIA, underperformed by 22%.

Full Story: http://seekingalpha.com/article/140487-do-inverse-etfs-do-what-they-re-supposed-to

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NYSE:DOG, NYSE:DUG, NYSE:DXD, NYSE:FXP, SRS