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Inverse exchange-traded funds (ETFs) seek to deliver inverse returns of underlying indexes. To achieve their investment results, inverse ETFs generally use derivative securities, such as swap agreements, forwards, futures contracts and options. Inverse ETFs are designed for speculative traders and investors seeking tactical day trades against their respective underlying indexes.
Inverse ETFs only seek investment results that are the inverse of their benchmarks' performances for one day only. For example, assume an inverse ETF seeks to track the inverse performance of Standard & Poor's 500 Index. Therefore, if the S&P 500 Index increases by 1%, the ETF should theoretically decrease by 1%, and the opposite is true.
Inverse ETFs carry many risks and are not suitable for risk-averse investors. This type of ETF is best suited for sophisticated, highly risk-tolerant investors who are comfortable with taking on the risks inherent to inverse ETFs. The principal risks associated with investing in inverse ETFs include compounding risk, derivative securities risk, correlation risk and short sale exposure risk.
Compounding risk is one of the main types of risks affecting inverse ETFs. Inverse ETFs held for periods longer than one day are affected by compounding returns. Since an inverse ETF has a single-day investment objective of providing investment results that are one times the inverse of its underlying index, the fund's performance likely differs from its investment objective for periods greater than one day. Investors who wish to hold inverse ETFs for periods exceeding one day must actively manage and rebalance their positions to mitigate compounding risk.
For example, the ProShares Short S&P 500 (NYSEARCA: SH) is an inverse ETF that seeks to provide daily investment results, before fees and expenses, corresponding to the inverse, or -1X, of the daily performance of the S&P 500 Index. The effects of compounding returns cause SH's returns to differ from -1X those of the S&P 500 Index.
As of June 30, 2015, based on trailing 12-month data, SH had a net asset value (NAV) total return of -8.75%, while the S&P 500 Index had a return of 7.42%. Additionally, since the fund's inception on June 19, 2006, SH has had a NAV total return of -10.24%, while the S&P 500 Index has had a return of 8.07% over the same period.
The effect of compounding returns becomes more conspicuous during periods of high market turbulence. During periods of high volatility, the effects of compounding returns cause an inverse ETF's investment results for periods longer than one single day to substantially vary from one times the inverse of the underlying index's return.
For example, hypothetically assume the S&P 500 Index is at 1,950 and a speculative investor purchases SH at $20. The index closes 1% higher at 1,969.50 and SH closes at $19.80. However, the following day, the index closes down 3%, at 1,910.42. Consequently, SH clos