What is Liquidity Risk for Inverse ETFs?

Investors should be wary of liquidity risk with some inverse ETFs (and ETFs in general). The ETFs with liquidity issues tend to be newer funds or those reflecting a style that is out of favor. As a result, they fail to garner enough assets under management. Some small inverse exchange traded funds have very low trading volume. When an inverse ETF has low trading volume it naturally has fewer market makers. Fewer market makers means less competition and could result in a wider bid-ask spread. In other words, you could pay more for simply buying and selling the ETF.

Some ETFs need to be rebalanced frequently and this could increase costs. We saw how ETFs in general had issues in August of 2015 on the morning of that flash crash when certain key components (stocks) of the ETFs were having trouble opening after market makers stepped away. This caused a spiral where the ETF then traded much lower because the market makers couldn’t assess the true value of the ETF (as the sum of its holdings) and temporarily stopped making real markets. As a result, spreads widened significantly. It should be noted that this pertained more to traditional ETFs, not inverse ETFs in August.

This could occur not just at the open but if a highly concentrated ETF has components that are getting repeatedly halted by circuit breakers (alerts on the NYSE where stocks that go down a certain percentage get automatically halted for a period of time). If you needed to buy or sell this ETF in those volatile periods, you could run into problems until things calm down and all the stocks open.

Inverse ETFs that might be out of favor (or other issues) might have only a few million in assets under management. If this continues for an extended period of time, the inverse ETF’s issuer might decide to close the fund. Now this doesn’t mean that you’re money is somehow gone, it just means the process of returning money to shareholders begins. There have been several inverse ETFs that issuers have closed down.

Other Inverse ETF risks include: