A risk associated with the use of inverse ETFs has to do with ‘suitability’. For certain investors, risk tolerance and investment objectives should be analyzed and may disqualify the use of inverse ETFs (check with your financial advisor to understand the nuances).
Inverse ETF suitability could make it’s way into fiduciary conversations. For investors with a low risk tolerance it may be wise to be wary of these funds and know the risks. This may seem counter-intuitive since inverse ETFs are designed to go up in value when the index or benchmark it tracks goes down. While this appears to be the intent of the strategy, it has some issues that must be addressed.
Inverse ETFs attempt to achieve their goal of inverse movement to an index through the use of derivative contracts (often swaps) with counterparties (usually financial firms). There are typically no ‘assets’ other than these derivative holdings in the inverse ETF. This may disqualify some investors with a stated low risk tolerance and other qualifiers.
Remember, most inverse ETFs are designed to track their benchmark over the course of a single day. Holding periods longer than this typically don’t track the benchmark well. The longer the holding period the more likely it will stray from tracking the performance of the underlying benchmark. Many brokerage and retirement accounts, when opened, are designed to be long term (buy and hold type) investments so having an inverse ETF, even if the intention is to hedge or even diversify (market direction) it may not be suitable due to the conflict with the holding periods.
This is especially true for leveraged inverse ETFs. Retirement accounts are designed for safety in mind and leveraged inverse ETFs are probably not a great idea for the average retiree. They incorporate risks that run contrary to objectives of a typical retirement account (especially if the investor is very close to or already in retirement). These risks including 1-leverage 2-the use of derivatives 3- unsuitable holding periods and potentially others including concentration (if there was only a small number or one counterparty).
It may be argued that one could trade the inverse ETF on a daily basis a hedge therefor not violating suitability for the holding period. But this could be construed as overtrading or churning. There have been times when a holding period longer than a day has tracked well, even better than might have been anticipated, it depends on the strength of the market movement and other variables.
Either way, inverse ETFs are designed for active management, not passively holding for weeks or months on end. Some IRAs may not allow them to be included as an investment. But an investor with a higher risk tolerance and longer time until retirement and more experience should be allowed to purchase these in a standard (non-retirement) account.
Consult with your financial advisor regarding the suitability of inverse ETFs for your unique situation and also read and understand the prospectus for the funds.
Other Inverse ETF risks include: