What are the potential risks of investing in inverse funds such as XIV and SPXS?

 

   Investing in inverse funds, such as XIV (which was an inverse VIX exchange-traded note) and SPXS (Direxion Daily S&P 500 Bear 3X Shares), can be appealing to investors seeking to profit from declines in specific market indices. However, these investments come with substantial risks. Understanding these risks is crucial for any investor considering inverse funds as part of their portfolio.

 

Market risks

 

   Loss Amplification: Inverse funds, particularly leveraged ones like SPXS, amplify the movements of the underlying index. For instance, SPXS aims to deliver three times the inverse daily performance of the S&P 500. While this can result in substantial gains if the market declines, it can also lead to significant losses if the market rises. The amplification effect makes these funds much riskier than their non-leveraged counterparts. Investors can quickly find themselves in positions where their losses far exceed their initial investment, especially during sharp market upturns.

 

Short-term focus:  Most inverse funds are designed for short-term trading, typically holding positions for a single day. The compounding effect of daily returns can lead to significant deviations from the intended performance over longer periods. This makes them unsuitable for long-term investors who might not have the time or expertise to monitor and adjust their positions daily. For instance, an investor holding SPXS over several months, even during a generally declining market, might find that the fund’s performance does not match the expected inverse multiple due to the effects of daily compounding and market volatility.

 

Structural risks

 

Volatility risk:  Inverse funds are highly sensitive to market volatility. High volatility can erode the value of these funds over time, even if the underlying index moves in the anticipated direction. For example, during periods of high market turbulence, the value of XIV or SPXS can decline significantly due to the compounding of daily returns. The higher the volatility, the greater the potential for losses, making these funds particularly risky in uncertain market environments.

 

Decay in value:  Leveraged and inverse funds suffer from decay, a phenomenon where the fund's value diminishes over time due to the daily resetting of positions. This decay is more pronounced in volatile markets and can result in substantial losses for investors holding these funds for extended periods. The daily reset means that each day’s returns are based on the fund’s current value, leading to a compounding effect that can erode the fund’s value, especially when the market is choppy.

 

Liquidity risks

 

Market liquidity:  Inverse funds might experience liquidity issues, especially during times of market stress. Low liquidity can lead to wider bid-ask spreads, increasing the cost of trading. Additionally, in extreme market conditions, it might become challenging to buy or sell these funds at desired prices. This can be particularly problematic for investors who need to exit positions quickly to mitigate losses, as they might find themselves unable to do so without incurring substantial costs.

 

Redemption risk:  Some inverse funds, particularly exchange-traded notes (ETNs) like XIV, are subject to redemption by the issuer. If the fund’s value drops below a certain threshold, the issuer might redeem the notes, potentially leading to significant losses for investors. This was evident in the case of XIV, which was liquidated after a sharp increase in volatility in February 2018. Such redemptions can catch investors off guard and lead to substantial, immediate losses.

 

Management and operational risks

 

Tracking error:  Inverse funds may not perfectly track the inverse performance of their benchmark indices. Tracking error can arise from various factors, including fees, expenses, and differences in the calculation methodologies. Investors might end up with returns that are lower than expected due to these discrepancies. This risk is exacerbated in leveraged funds, where small errors in tracking can lead to significant deviations in performance over time.

 

Counterparty risk:  For ETNs, the credit risk of the issuing institution is a significant factor. If the issuer faces financial difficulties, investors might not receive the expected returns, or they could lose their entire investment. This counterparty risk is less pronounced in ETFs but still exists to some extent. The financial health and stability of the issuing institution thus become critical considerations for investors in ETNs.

 

Regulatory and market environment risks

 

Regulatory risks:  Inverse funds are subject to regulatory scrutiny, and changes in regulations can impact their operations. For instance, regulators might impose stricter rules on leverage or limit the availability of certain products, affecting the performance and accessibility of inverse funds. This regulatory uncertainty can add an additional layer of risk for investors, as changes in rules or enforcement can significantly impact the value and usability of these funds.

 

Market environment changes:  Changes in the overall market environment, such as shifts in monetary policy, economic conditions, or geopolitical events, can have unpredictable impacts on inverse funds. These macroeconomic factors can influence market volatility and direction, adding another layer of risk for investors. For example, unexpected changes in interest rates or international conflicts can create market conditions that adversely affect the performance of inverse funds.

 

Psychological risks

 

Behavioral risks:  Investing in inverse funds requires a strong understanding of market dynamics and a disciplined approach. The potential for large gains can lead to overconfidence, while significant losses can result in panic selling. These behavioral biases can exacerbate losses and undermine investment strategies. The allure of high returns can lead to risky behavior, such as over-investing or failing to properly manage risk, which can result in significant financial damage.

 

Complexity and understanding:  The complex nature of inverse and leveraged funds can be challenging for average investors to understand. Misunderstanding how these funds operate, particularly the impact of daily resets and compounding, can lead to misguided investment decisions and unexpected losses. Investors may not fully grasp the nuances of these instruments, leading to strategic errors and financial losses.

 

Case Studies: XIV and SPXS

 

XIV (VelocityShares Daily Inverse VIX Short-Term ETN):  XIV aimed to provide the inverse return of the VIX short-term futures index. During periods of low volatility, XIV performed well, attracting significant investor interest. However, the fund’s structure made it vulnerable to sudden spikes in volatility. In February 2018, a sharp increase in the VIX led to XIV losing more than 90% of its value in a single day, resulting in its liquidation. This dramatic collapse highlights the extreme sensitivity of inverse volatility products to market changes.

 

SPXS (Direxion Daily S&P 500 Bear 3X Shares):  SPXS seeks to deliver three times the inverse daily performance of the S&P 500. While this leverage can result in substantial gains in a declining market, it also exposes investors to amplified losses in a rising market. The daily reset mechanism and compounding effect mean that SPXS can underperform over longer periods, even if the S&P 500 declines. The fund’s performance can deviate significantly from its target over time, making it a poor choice for long-term investment.

 

Conclusion

 

    Investing in inverse funds like XIV and SPXS involves significant risks that can lead to substantial losses. These risks include market volatility, decay in value, liquidity issues, tracking errors, counterparty risk, regulatory changes, and psychological factors. Investors must thoroughly understand these risks and consider whether inverse funds align with their investment objectives and risk tolerance.

 

   For most investors, the complexity and heightened risk of inverse funds make them more suitable for short-term trading rather than long-term investment strategies. Inverse funds can serve as useful tools for hedging or speculative purposes, but they require a high level of expertise and active management to mitigate their inherent risks. Without a deep understanding of how these instruments work and a robust risk management strategy, investors may find themselves facing unexpected and substantial losses. Therefore, while inverse funds can offer significant rewards, they should be approached with caution and a thorough understanding of their risks and operational mechanisms.