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Are Rising Rates Giving This Inverse ETF a Shot at Redemption?

We examine the problems with hedging your portfolio with inverse ETFs.

Tim Strauts, 06/10/2013

The sharp rise in interest rates over the past month has caught many investors by surprise. Yields on 10-year Treasury bonds have risen from 1.6% to 2.1% since May 1. During this period, iShares Barclays 7-10 Year Treasury Bond ETF IEF declined 3.2%. The prospect that yields may march higher has many bond investors seeking protection from interest-rate risk. Some are rotating into shorter-duration fare, others are investing in floating-rate instruments, and some may even be considering an exchange-traded fund that provides inverse exposure to Treasury bonds.

The thought process of the last group might go something like this:

"I have a large fixed-income portfolio and I'm concerned about rising interest rates. I don't want to liquidate all or a portion of my fixed-income portfolio, because I rely on the income that these bonds are producing. I would like to find a way to hedge my interest-rate risk with a small portion of my portfolio. If interest rates rise, long-term bonds will suffer the most given their high duration. So if I buy a double-leveraged inverse-bond ETF on long-term Treasuries, I will be able to insulate my fixed-income portfolio with a relatively small allocation to the inverse ETF."

Is this investor on to something? Let's take a closer look at ProShares UltraShort 20+ Year Treasury TBT to find out.

Double-Short Inverse Treasury ETF
ProShares UltraShort 20+ Year Treasury seeks daily investment results, before fees, expenses, and interest income earned on cash and financial instruments that correspond to twice (200%) the inverse of the daily performance of the Barclays 20+ Year U.S. Treasury Index. That means that when the Barclays 20+ Year U.S. Treasury Index is down 5% for the day, this fund should be up 10%, and vice versa. The ETF typically tries to capture this return by taking positions in derivative instruments--typically swaps and futures contracts.

Investors should bear in mind that this fund likely will not deliver exactly double the index's inverse return over holding periods lasting longer than a single day. The chart below shows the returns of ProShares UltraShort 20+ Year Treasury and iShares Barclays 20+ Year Treasury Bond TLT. Both funds track the same index. Since Oct. 1, 2011, TLT's returns declined by 1.21%. Those that fail to understand the compounding arithmetic inherent in this fund's long-term returns might expect that TBT would have returned a positive 2%-3% over this same span. As can be seen below, TBT actually declined by 11.76% during this period. For a more thorough explanation of the thorny issues facing leveraged ETFs read, "Warning: Leveraged and Inverse ETFs Kill Portfolios."


Source: Morningstar.

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