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Monday, November 2, 2009

Inverse Etfs....As I Was Saying

The WSJ's James Stewart may be a bit confused about them (see oct 29 blog entry), but the FT is quite clear on how imperfect a hedge vehicle they are: my bolds and italics

Upside-down’ investors may not see risks
By Sophia Grene

Index tracking or passive investment is now well established as a sensible form of investing. But what if you believe the index in question is likely to fall? Or you think it will rise and you want to exploit your belief to the utmost?

For investors with those beliefs, there are inverse and leveraged indices. Although these sound straightforward – just take an index and turn it upside down! – it does not work quite as simply as that.

An inverse index is constructed by calculating the return of an index, including price movements and dividends, then reversing it. They are most often used as the underlying index for an exchange traded fund, and many investors see them as an alternative to shorting an index. This is particularly useful for those whose investment mandates do not allow them to short directly, just as a leveraged index ETF, which offers multiples of an index’s returns, directly or inverse, gets around restrictions on leverage.......


However, regulators are now looking closely at how they function and whether they are being properly represented to investors.

Almost all of the inverse products rebalance daily, which is no problem if the market is moving smoothly in one direction. More volatility makes it more complicated, as daily rebalancing means the inverse index returns can veer far away from the return one might expect with a naïve calculation of the return of the long-only index and finding its inverse.

If a long only index declines by 10 per cent over a year, an unsophisticated investor might expect to receive a 10 per cent gain from an inverse index ETF.(take note Mr, Stewart of the WSJ) This is relatively unlikely, as the index returns only the inverse of each day’s return, rather than that of a year’s return. ...

In the US, the Financial Industry Regulatory Authority (Finra), the largest independent regulator for US securities companies, warned in June that these products were not suitable for retail investors who plan to hold them for more than one trading session.....

In July, UBS suspended sales of inverse and leveraged ETFs in the US, explaining in an official statement that “the short-term nature of these securities is generally inconsistent with the long-term view of investing that UBS advocates when building client portfolios”.
Maybe some wsj readers are UBS clients and therefore will be saved the opportunity to replicare Mr. Stewart's "experiment:.

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