3 Best Inverse ETFs for 2018
(Read Time: About 2 minutes)
It’s a bit early for a ‘New Year’ article but the current inflection point is so critical we had to go to press early. Each member of our Best Inverse ETFs for 2018 list targets a different bubble of an asset class- stocks, bonds and [low] volatility. Within this confluence of manias, we selected those ripest for a reversal. We believe these are big-cap technology, high-yield bonds and volatility.
1- PSQ (the ‘Short QQQ’ Inverse ETF)
While all major U.S. equity markets are overvalued to some extent, none are as extended technically as the Nasdaq 100. The tech-heavy list of the 100 largest NASDAQ stocks is now up an astounding 720% from its Financial Crisis lows, more than any other major index by far. This rise is not sustainable.
But the most dangerous aspect of this index is the high level of concentration. The top five holdings, Apple, Alphabet, Microsoft, Amazon and Facebook represent 44% of the entire index.1 We saw in 2015 what happened to the NASDAQ 100 tracking index (QQQ) when some of the underlying holdings couldn’t open for trading due to volatility-the QQQ plummeted from roughly $105 to $85. That’s nearly 20% of the index wiped out in a flash.
The NASDAQ 100 is also diverging from the broader NASDAQ which is enduring over 40% of its stocks below their 200 Day Moving Averages. Technically, something has to give.
Tech bulls will argue that this is not the Dotcom Bubble 2.0 since today’s members have real earnings. There is always a strong fundamental justification near a top. Yes, they do have earnings but that doesn’t mean their stock prices can’t be cut in half. Just yesterday we watched Priceline drop $260 dollars per share during the afternoon. With so many market sentiment indicators off the charts, the turn is near.
The ProShares Short QQQ ETF, PSQ, attempts to return the inverse/opposite of the NASDAQ 100 index’s return on a daily basis. For investors with a higher risk tolerance, this fund could provide a nice hedge against a major tech downturn.
2- SJB (‘Short High Yield’ Inverse ETF)
Persistently low interest rates have pushed many investors further out on the risk spectrum. With U.S. Treasury bond rates in the 2% range and savings accounts yielding nil, the only game in town has been riskier, non-investment grade corporate bonds with [relatively] higher yields. Known as junk bonds, they also have record long durations and low covenant protections have been largely ignored for a few extra basis points.
Unfortunately, these bonds have gotten so overbought (aided by passive high yield ETFs yields) that the yields now are paltry compared to their associated credit risks. On the iShares iBoxx High Yield Corporate Bond ETF, HYG, investors can now expect only about a 5% yield for lending to some of the worst capitalized companies in the U.S. (and that’s before an expense ratio brings yields down to about 4 ½%).2 The fund is comprised of mostly BB and single-B rated corporate bonds.
It’s even worse overseas. The European high yield bond market has been gobbled up so much, there is actually a negative spread between that market and United States 10-year Treasury bonds. European junk bonds are yielding roughly 2.17% while the U.S. 10 year Treasury offers 2.31% today.3 The ‘better’-rated BB debt yields just 1.6%.4 This implies a negative default rate (in other words, no possibility of default) according to Fundstrat’s Tom Lee.5 This insanity is an unintended consequence of negative yielding government bonds.
Further, pension funds and insurance companies hold billions of dollars’ worth of junk bonds to match their future liabilities. If these institutions need to sell their holdings in a liquidity crunch they could rush out of their junk bond positions, selling the ‘best’, most liquid, ones that they can. The worst ones aren’t likely to even be tradable. Then you’ll see the real carnage.
The ProShares Short High Yield ETF, SJB aims to return the inverse/opposite of the Markit iBoxx Liquid High Yield Index’s return for a single day. These high yield inverse etfs are a play on the [inevitable] popping of the corporate bond bubble. HYG and its ‘junkier’ counterpart, JNK have enjoyed record inflows, but they could quickly see that money find a new home. The result could be a downward spiral as underlying physical bonds may be unable to be sold in an illiquid environment. SJB could prove to be one of the best inverse etfs of all.
3- VXX (‘VIX Futures ETN’)
While our next fund isn’t technically an inverse ETF, it mimics equity inverse ETFs as part of a bear market strategy. The Barclay’s I-Path S&P 500 VIX Shares, VXX, is a volatility exchange traded note designed to track the CBOE Market Volatility Index, VIX.
Known as the ‘Fear Gauge’, the VIX is basically the price of insurance against the market, as measured by S&P put options. When the market sells off, especially in a crisis or panic, the VIX generally goes up.
The sustained, historic trough in volatility has lured many investors into an amazing sense of complacency. Further, many professionals have caught onto the natural negative roll yield that plague long VIX products and have been actually ‘shorting’ volatility to record levels. In fact, October was the least volatile month in the 27-years of recording the VIX, according to the CBOE.
In total, $2.4 billion is now invested with inverse volatility ETFs, according to Bloomberg.6 This amount is larger than fund allocations to some countries they add. The market’s reversal, when it happens, should cause the VIX to explode higher, helped along by the pending short covering.
There are a number of related strategies such as low-volatility ETFs, option writing and risk parity which may add fuel to the fire if volatility rises. The rubber band is stretched about as tight as it will go.
But the key is timing, since the VXX doesn’t do a great job of tracking the VIX over longer periods. If the VIX doesn’t move much, the tracking ETF is still likely to decay in value, similar to an option. Also, it’s not just about the level of the VIX, it also has much to do with the shape of the VIX futures curve. With the VXX, we are expecting short-term volatility to increase and the VIX curve to flatten. This happens when the underlying VIX increases since it’s the nearest ‘future’ (the spot price).
Normally, a long volatility ETF is almost a guaranteed loser, except right before a severe market correction. The timing could be just right for VXX.
This article is for entertainment purposes only. Volatility and inverse ETFs/ETNs are not suitable for many investors, especially those with low risk tolerances. Always consult with a financial professional about ways to reduce portfolio risk pertaining for your unique situation. These products have not been fully-battle tested through a bear market and contain many risks. Read the fund’s prospectus for a list of all features and risks.