Q: Experts are calling for a recession. Would adding shares of an inverse ETF to my portfolio help protect me?
It's true that if a recession hits and the stock market goes down rapidly, an inverse ETF based on a broad index like the S&P 500 is likely to rise. However, there are a few reasons why adding an inverse ETF to your portfolio is still a bad idea.
First, inverse ETFs put you at an inherent mathematical disadvantage over long time periods because they are intended to reflect the daily performance of an index.
Without getting too deep into the math, let's say that a hypothetical stock index falls from 1,000 to 800 over a two-day stretch, 100 points per day. On the third day, it rapidly rebounds to its original level of 1,000.
In this case, simply shorting the index would break even. On the other hand, the inverse ETF would have gained 10% on the first day, 11% on the second (900 to 800 is a 11% loss), but would have lost 25% on the third day (800 to 1000 is a 25% gain), resulting in a three-day loss. This effect is amplified even further if you buy a leveraged inverse ETF that seeks to double or triple the index's daily returns.
What's more, inverse and leveraged ETFs tend to have higher expense ratios than standard ETFs. This serves to further amplify the disadvantage.
Last, but certainly not least: Don't try to time the stock market. A recession could hit within the next few months, or not for several more years. Nobody knows. The market has an upward bias over time, with the S&P 500 averaging total returns of about 10% per year, and it's historically been unwise to bet against it.
In a nutshell, inverse ETFs are designed to be very short-term investments. Long-term investors would be wise to avoid them and just stay focused on buying great investments to hold.