Compounding risk (sometimes called volatility risk, or delta risk) refers to the amount an inverse ETF diverges from its benchmark over time (longer than one day). The greater the holding period, especially given choppy (volatile) markets, the more the inverse ETF’s price should diverge from its index, even if the fund tracks the index well on a daily basis.
This is more of a math issue than the inverse ETF itself. The investor needs to understand the strengths and weaknesses of the inverse ETF and that the design is simply to replicate an underlying benchmark, or its inverse, for a single day. Any longer holding period than one day results in less effective tracking of the benchmark.
This compounding risk is exacerbated, the more the inverse ETF is leveraged. Think of an inverse ETF as an ‘on demand’ hedge which is best served the shorter it is kept on, given the tendency for markets to naturally fluctuate. Say you have $100 invested in an inverse ETF on the S&P 500:
|ETF Daily Starting Value||Benchmark Return||ETF Daily Ending Value|
If held longer than one day (on daily rebalanced inverse ETFs) a volatile, choppy market erodes an inverse ETF’s value (in this example, by almost 3%). If held longer than one day, which is not what they are designed for, inverse ETFs work better in a trending market, where the majority of days movements are in one direction. The safer strategy would be to, on Day 1, buy an inverse ETF as a hedge after noticing the market opened up 10%. Then if the market reversed course and went down 10% that day, you could then sell it near the close, capturing the profit from the hedge quite well.
Other Inverse ETF risks include: