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As the Coronavirus Crash intensified in March, investors sifted through their portfolios in the hope that something, somewhere, was holding up.
There were not many assets that were, but holders of BetaShares’ “short” funds, which are designed to generate a return that is negatively correlated to the return of either the Australian or the US share market, were certainly in that category – because that’s exactly what they were designed to do.
The three funds are “inverse” exchange-traded funds (ETFs), structured to rise when a share market index falls. They take a “short” position on their respective indices, by selling futures contracts over those indices.
Two of the ETF issuer’s Bear Funds are geared (leveraged) so as to potentially magnify the profit from the “short” strategy.
The simplest of the Bear Funds, being ungeared, is the BEAR fund (that is the ASX code), which simply targets a return that is negatively correlated with the return of the Australian share market, in a roughly one-to-one relationship. In effect, if the fund’s benchmark index – the S&P/ASX 200 Accumulation Index, which includes dividends – falls by 1%, the fund should rise by somewhere in the range of 0.9%–1.1%. The reverse is also true if the S&P/ASX 200 Accumulation Index rises by 1%, the BEAR fund will fall by 0.9%–1.1%.
The other Australian Bear Fund, the BBOZ (ASX code) fund, is also designed to be negatively correlated with the return of the S&P/ASX 200 Accumulation Index, but in a magnified way to try to achieve a return of 2%–2.75% for every 1% fall in the S&P/ASX 200 Accumulation Index. And, of course, the opposite reaction in the event of a 1% rise in the index.
The third product, the US Equities Strong Bear Hedge Fund – Currency Hedged (ASX code: BBUS) is designed to generate magnified positive returns when the US market (as represented by the S&P 500 Total Return Index, which includes dividends) goes down, and vice versa. deliver a 2% to 2.75% increase in the value of the Fund (and vice versa). It is also designed to deliver a return of 2%–2.75% for every 1% fall in the benchmark index (and vice versa).
The tale of the tape is that in the Coronavirus Crash, all three funds did what they said they would do.
The BEAR fund gained 16.9% in March, compared to a fall of 20.7% in the S&P/ASX 200. For the March 2020 quarter, BEAR was up by 20.1%, versus a 23.1% slump in the index.
As investors would expect, BBOZ, the geared Australian short fund, did even better; it was up by 33% in March, compared to the 20.7% fall in the S&P/ASX 200; for the March quarter, BBOZ rose by 40.6%, against the 23.1% fall in the index.
BBUS, the leveraged US fund, surged by 22.6% in March, compared to its benchmark index, the S&P 500 Total Return Index (which includes dividends), in US$. For the March quarter, BBUS gained 47.8%, versus a fall of 19.7% for the index.
That is passing the acid test with flying colours, and investors certainly noticed. Ilan Israelstam, co-founder and head of strategy and marketing at BetaShares, says that on “many days” in March, the BBOZ fund traded more than Telstra did; in the month of March, BBOZ did $2 billion worth of trade – making it the most-traded exchange-traded product (ETP) in the Australian market.
That’s not to say it was all smooth sailing.
The three funds work by selling futures contracts over their respective indices. That means that the market prices of the short funds on the ASX reflect futures prices – not the price level of the share market index. The relationship between the futures price and the physical index price for the two Australian funds should be reasonably close, but for BBUS, the price during the Australian trading day is totally futures-driven, because the US share market is closed.
This caused a few difficulties in March, when US share markets – physical and futures – experienced some of the most volatile trading in the past decade, as investors struggled to absorb the impact of the COVID-19 pandemic on countries and economies, and the responses of governments. Several times, US share index futures fell more than 5%, and went “limit down” – they are not allowed to move any lower, and trading is suspended for 15 minutes. (They can also trigger “limit up,” or a 5% rise, in an optimistic market.)
There were occasional price dislocations during the Australian trading day with BBUS – as there were with any ASX-traded instrument that needs futures trading to price, during the Australian trading day – on these occasions, as market-makers tried to price the ETFs as best they could. Market-makers were occasionally flying blind, but they could use alternatives such as the Nasdaq 100 index futures, which give a very close correlation to the S&P 500.
Israelstam says financial advisers mostly use the inverse ETFs in client portfolios for hedging purposes. “We’re really talking about partial hedging – it would be too capital-intensive to have an Australian share portfolio hedged dollar-for-dollar. We typically find that clients use these as they would use a so-called ‘alternative assets’ allocation, where they’re really thinking about not wanting to be as exposed to equities – alternatives allocations are typically in the range of 5%–10%, and that’s where they would use these products.
“If you had something in your portfolio in March that went up by 17% – or in the case of BBOZ, went up by 33% – even a partial holding it would have made a big difference to the performance of a portfolio over that month,” says Israelstam.
“Even if someone just had 10% in BEAR, they have something in their portfolio that’s negatively correlated to the share market. It is lessening the pain, and they’re hoping that eventually, everything else comes back. We also see investors using these products where they want to take off some of their equity exposure on the market, but they don’t want to sell any holdings and initiate a tax event – so they buy an inverse ETF and take some share market exposure off that way. This can be put into self-managed super funds (SMSFs), because there’s no recourse, there’s no loan or margin calls or anything like that, and of course it is tradeable on the ASX.”
Clearly, the inverse products can also be used for speculative purposes. “They are very actively traded, and there are definitely people using them on-and-off. We think it adds to the market to have something like this. Until this was around you couldn’t do something like this as a retail investor. Very few retail investors want to set up futures accounts, to be able to act on their view that the share market might fall; and contracts for difference (CFDs) are even worse, because that also has margin calls, and it is a separate trading platform that you have to set up. Obviously, some buyers of the inverse funds like being able to use an ASX-listed product to trade their view of the market.”
The inverse funds are at the expensive end of the ETF spectrum, with all three costing 1.38% a year.
The obvious problem with such products, which offer protection when the market falls, is that the inverse relationship means that holders will lose if the market gains.
For example, in the oldest fund, BEAR, if an investor had owned it since inception in July 2012, BEAR has lost 6.3% a year as at the end of March 2020, while the S&P/ASX 200 Accumulation Index has gained 7.2%.
For the three years to end of March 2020, BBOZ (launched in April 2015) would have lost 6.7% a year, more than the S&P/ASX 200 Accumulation Index’s loss of 0.6% a year. Over the same period, BBUS (launched in August 2015) would have lost 16% a year, while the S&P 500 Total Return index gained 4.5% a year.
That represents the cost of protection; but it also ignores the likelihood that many investors would have come into these funds progressively through 2019 – and in early 2020 – as markets started to look increasingly toppy. And for those prescient (or fortunate) investors, the inverse ETFs did give the performance in a crash that they promised.