Inverse ETFs in Canada

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An Inverse ETF (Exchange-Traded Fund) is a financial instrument designed to deliver the opposite performance of a specific underlying index or asset. It achieves this inverse relationship using derivatives like swaps or futures contracts. It is typically used by investors who want to profit from a decline in the value of the underlying index or hedge against losses in their portfolio.

1. Performance Objective:
   • Inverse ETFs aim to provide returns that are the inverse (-1x) of the daily performance of their benchmark index. For example, if the benchmark index drops by 2% in one day, the inverse ETF should rise by approximately 2% in the same period (before fees and expenses).
2. Daily Reset:
   • These ETFs are designed to achieve their inverse performance on a daily basis. Over longer periods, compounding effects can cause the actual returns to diverge from the expected inverse performance, making them less suitable for long-term holding.
3. Leverage:
   • Some inverse ETFs are leveraged, offering -2x or -3x the benchmark's daily performance. For example, a -2x inverse ETF would gain 4% if the underlying index drops by 2% in one day.
4. Hedging and Speculation:
   • Hedging: Investors may use inverse ETFs to protect their portfolios during market downturns.
   • Speculation: Traders may use them to bet on a decline in the market or a specific sector.

1. Performance Objective: The mechanism of inverse ETFs incurs several costs, which are passed on to investors as part of the expense ratio:

   • Derivative Costs: Fees for entering and maintaining swaps or futures contracts.
   • Management Fees: Charged by the fund manager.
   • Transaction Costs: Arising from daily rebalancing and collateral management.

   These costs are higher than traditional ETFs due to the complexity of maintaining inverse exposure. As a result, inverse ETFs often have higher expense ratios due to the cost of managing derivatives.

2. Market Risk: If the underlying index rises, the inverse ETF will lose value.

3. Volatility Decay: Over time, the compounding effect of daily resets can lead to significant deviations from the expected performance.

Due to their complexity and risk profile, inverse ETFs are best suited for short-term strategies and require active management and monitoring.

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In Canada, Inverse ETFs work similarly to those in other markets, offering investors a way to profit from a decline in an underlying index or asset. They are regulated by the Canadian Securities Administrators (CSA) and available through major stock exchanges like the Toronto Stock Exchange (TSX).

Here’s how they operate within the Canadian context:

1. Mechanism:
   • Inverse ETFs in Canada use derivatives (e.g., swaps, futures contracts) to achieve their inverse performance. The fund manager enters into agreements with counterparties to create the desired inverse exposure to the benchmark index or asset. More specifically, the fund manager uses futures contracts, total return swaps (TRS), equity swaps, or commodity swaps to create a short position in the underlying asset.
2. Underlying Benchmarks:
   • Canadian inverse ETFs often track popular indices such as:
     • S&P/TSX 60 (large-cap Canadian companies)
     • S&P 500 Index (American market)
     • Nasdaq 100 (Non-financial, Nasdaq-listed large companies)
   • Some inverse ETFs focus on sectors (e.g., energy, financials) or specific asset classes like commodities or bonds.
3. Daily Objective:
   • Like their counterparts in other countries, Canadian inverse ETFs aim to deliver the inverse (-1x) of their benchmark's daily performance. Leveraged inverse ETFs may aim for -2x or -3x the daily return.

• BetaPro Inverse ETFs:
  • HIX: Horizons Inverse ETF that provides -1x exposure to the S&P/TSX 60 Index.
  • HBD: Provides -2x exposure to the Gold Price.
  • HND: Inverse -2x exposure to natural gas prices.

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From the start of 2023 until 21 November 2024, HQD (BetaPro Nasdaq-100 -2x Daily) has returned -72%, while Nasdaq 100 has returned 91%. From the start of 2024 until 21 November 2024, HQD has returned -35%, while Nasdaq has returned 26%.

1. Hedging:
   • Investors use inverse ETFs to hedge portfolios against market downturns. For example, if they hold Canadian equity positions, an inverse ETF on the S&P/TSX 60 can offset losses.
2. Speculation:
   • Traders may speculate on declines in Canadian indices, sectors, or commodities like oil or natural gas, which are prominent in Canada's economy.
3. Short Selling Alternative:
   • Inverse ETFs provide a simpler, cost-effective alternative to short selling. There’s no need to borrow stocks or worry about margin calls. Short selling is impossible in registered accounts, and inverse ETFs can play its role.

Inverse ETFs in Canada are regulated by the Canadian Securities Administrators (CSA), which enforce disclosure rules and operational standards. Key regulatory points include:

• Prospectus Requirements: Inverse ETFs must clearly disclose risks, including compounding and counterparty risk.

• Derivatives Regulation: Compliance with provincial securities laws on derivative use.

• Derivatives Disclosure: Canadian inverse ETFs must disclose the use of derivatives in their prospectuses and highlight associated risks.

• Tax Implications:
  • Gains or losses from inverse ETFs are treated as capital gains or losses for tax purposes.
  • Inverse ETFs can distribute taxable income, even in losing years, due to their derivative strategies.

• Risk Warnings: Canadian regulators require inverse ETF providers to warn investors about the potential for volatility decay and the unsuitability of these products for long-term investing.

1. Compounding Effect:
   • Over multiple days, the performance of an inverse ETF may deviate from the expected inverse of the index due to the compounding of daily returns, which are affected by fees. This is especially pronounced in volatile markets.
2. Liquidity:
   • Inverse ETFs in Canada generally have good liquidity, which can vary depending on the ETF and market conditions. The liquidity of an ETF, in general, is determined by the liquidity of its underlying asset.
   • This is because if higher demand for ETFs pushes their price significantly higher than their net asset value (NAV), an authorized participant (AP) delivers underlying assets for asset-backed ETFs or equivalent cash for synthetic ETFs to the ETF manager in exchange for ETF units, which they would proceed to sell in the secondary market.
   • If, on the other hand, lower demand for ETF units pushes its price below the ETF’s NAV, the authorized participant would buy units of the ETF in the open market and offer them to the ETF manager in exchange for the ETF’s underlying assets in the case of asset-backed ETFs and cash in the case of synthetic ETFs.
3. Fees:
   • Management fees for Canadian inverse ETFs tend to be higher than traditional ETFs due to the costs of managing derivative positions.

From the beginning of 2024 until 22 November 2024, HSD (BetaPro S&P 500® -2x Daily Bear) returned -33%, while the S&P 500 returned 26%. From the beginning of July 2024 until 22 November 2024, HSD returned -13.6%, while the S&P 500 returned 7.8%.

• Hedgers: Protect portfolios against market downturns.

• Traders: Speculate on short-term declines in indices, sectors, or commodities.

• Commodity Investors: Bet against natural gas, crude oil, or other commodities that dominate the Canadian economy.

• Active Traders: Those looking for short-term opportunities to capitalize on market downturns.

• Portfolio Managers: To protect against temporary market declines.

• Commodity Market Speculators: Given Canada’s resource-based economy, inverse ETFs tied to oil, gas, or other commodities are frequently used.

Inverse ETFs in Canada are powerful tools for tactical investing and risk management but should be used with caution, given their complexity and risks associated with compounding effects. They are suitable for experienced investors with a clear understanding of market dynamics.

• Inverse ETFs can be purchased through most Canadian brokerage platforms like:
  • Interactive Brokers Canada
  • moomoo
  • CIBC Investor’s Edge

The mechanism of inverse ETFs in Canada involves using financial derivatives to achieve the opposite performance of a specific index or asset. Effectively, the ETF manager creates a synthetic short position in the underlying asset. Here’s a breakdown of how they work, step by step, with details tailored to the Canadian context:

1. Tracking the Underlying Benchmark

• Inverse ETFs are designed to move in the opposite direction of a benchmark, such as:

  • Equity indices: (e.g., S&P/TSX 60, S&P/TSX Composite).

  • Commodities: (e.g., natural gas, crude oil).

  • Currencies: (e.g., CAD/USD exchange rate).

The ETF's daily performance is engineered to achieve a -1x, -2x, or even -3x return on the benchmark's daily performance.

From 2 July 2024 until 22 November 2024, HOD (BetaPro -2x Crude Oil Inverse Leveraged Daily Bear) has returned 6.9%, while WTI has returned -13.6%. From 1 October 2024 until 22 November 2024, HOD has returned -10.76%, while WTI has returned 1.99%.

2. Use of Derivatives

Inverse ETFs rely on derivatives to create their inverse exposure. In Canada, the most commonly used derivatives include:

• Swaps:
  • Agreements with counterparties (usually large financial institutions) to exchange returns. The ETF pays the counterparty the actual return of the index, and the counterparty pays the ETF a fixed or variable interest rate.
• Futures Contracts:
  • The ETF shorts futures contracts to profit from a decline in the underlying asset or index price.
• Options:
  • A synthetic short position can be created by selling a call option and buying a put option at the same strike price.

3. Daily Resetting

Inverse ETFs in Canada reset their exposure daily to maintain their inverse performance goal. This means that:

• The ETF adjusts its derivative positions at the end of each trading day to ensure it matches the inverse of the next day's benchmark performance.

For example:

• If the S&P/TSX 60 drops 1% today, an inverse ETF tracking this index would gain approximately 1% on the same day.
• The positions are recalibrated overnight to target the next day’s performance.

4. Rebalancing Mechanism

To maintain the inverse exposure, the ETF must rebalance its derivatives daily. This involves:

• Adjusting Contracts:
  • Increasing or decreasing the notional value of swaps or futures based on market movements. When the ETF is leveraged, this means that the ETF has to increase its exposure each time the price of the underlying increases, and it has to reduce its exposure each time the price of the underlying asset decreases. This rebalancing means that a leveraged ETF is engaged in buying high and selling low. Buying high and selling low is the cause of volatility decay in leveraged ETFs, including inverse leveraged ETFs.
• Cash Management:
  • Using collateral, such as cash or Treasury securities, to back the derivative positions.

Rebalancing is key to achieving the daily inverse performance but also leads to compounding effects of fees over multiple days.

5. Collateral and Margin

• The ETF provider must post collateral to support derivative trades. In Canada, this usually involves:

  • Cash Reserves: Held to meet margin requirements.

  • Government Securities: Such as Canadian government bonds, which serve as collateral.

6. Counterparty Relationships

Since many inverse ETFs depend on swaps, they involve counterparty risk. The ETF provider (e.g., Horizons ETFs in Canada) enters into agreements with large financial institutions to execute these swaps. The provider’s credit risk is mitigated through collateral agreements and strict regulatory oversight.

The mechanism of inverse ETFs in Canada involves daily resetting and the strategic use of derivatives like swaps and futures to deliver the desired inverse performance. These ETFs provide a convenient way to hedge or speculate, but their daily reset and compounding effects require careful handling.