Inverse ETFs or exchange-traded funds were created by using various derivatives for the purpose of profiting from a decline in the value of an underlying benchmark or sector. These are also known as a "Short ETFs," or "Bear ETFs." During this lesson we'll go through the exact pricing of these ETFs (which nobody out there is covering correctly) and show you why over time these securities have a huge pricing lag that doesn't work in your favor. Plus we'll look at some specific examples with QQQ and QILD to give you a real life scenario to work with visually.

###### Transcript

We’re going to go over inverse ETFs on this particular video. As we all know, ETFs are very popular and becoming more popular. And as the development and issuance of regular ETFs, so have the issuance and development of inverse ETFs have started to ramp up really.

And, over last two or three years here, we have a lot of inverse ETFs that have started to come out. Not only that, but there’s also double-long, triple-long, triple-short, double-short, etcetera, etcetera.

What I wanted to go through here is a simple example that shows you guys some of the risks that are involved in some of these double and ultra-long and ultra-short ETFs. Follow along with me, it’s going to be easy, and then we’ll take a look at an actual example to prove and drive home the point here.

Inverse ETFs: Let’s use first a simple savings example just to get our bearings here. Let’s say we’re going to save $100 at 10% per year. After the first year as a simple math, we have $110 in our account or a $10 profit. We made 10% on our initial $100.

Let’s say we kept that money in the bank and after two years we have $121. Not another $10, but an actual $11 profit and that’s because we made an extra 10% on our $10 profit which is an extra dollar which is why we have $11.

After year seven, you can see we’d have about $195 which turns out to be about a 13.55% return. Not exactly the 10% return that we had initially thought. That would be simple interest, but we’re dealing with compound interest. Let’s now put that $100 into three different funds.

We’ll call Fund A just the simple index fund, and this could be anything from the SPY, to the DIA, to the Qs, etcetera. Fund B, let’s go into a double-long ETF, so a double-long or an ultra-long ETF. And then in Fund C, what we’re going to do is we’re going to go into a double-inverse ETF, so a double-short or an ultra-short.

Going over these, let’s assume that we get a 10% return today. ETF funds are calculated on a daily basis, not a monthly or yearly basis, so let’s say we get a 10% return today. And simple math here, after day one, Fund A which is just the index is $110. It started at $100, and it’s now at $110.

After day one, Fund B which is our double-long is going to be at $120, so we’re making double what the daily return is. The index return is 10% today. We’re going to make 20%, twice that value.

This is really where the advantages to these come into play. After day one, Fund C which is our double-short is going to lose 20%, so losing double what the index made. We’re going to be down $80 in that value for that portfolio.

Now, let’s move forward and let’s say that the next day, on day two, the index returns -10%, so on average, giving about a 0% gain, so it gives back all the gains from yesterday. But now, the numbers start to look a little bit different.

Fund A is at 99%. 10% of the $110 value which we were last at is $11, so we’re going to give back $11 if we lose 10% from there. Now, the fund is going to be just below breaking even. Fund B which is our double-long fund is going to give back 20% of our $120.

Remember it made 20% the first day, so we’re going to give back about $24 and be at $96, so below par. And Fund C was going to make 20% instead of losing 10%, 20% of $80 which is $16 and being back at $96.

You can see if we repeat this process for about six months straight, 10% up days followed by 10% down each day, Fund A which is our index would be at roughly 95.10% on average, Fund B and C would both be at approximately $2.54. You can see that both of these leveraged ETFs have lost nearly 97.5% of your investment.

Now, talk about a tracking error on the part of these ultra-fund brokerage houses, these are supposed to track them 10% up, 10% down, double up, double down, but you can see that if you actually do the math and work the numbers out that they actually start to lose money over the long run.

Let’s take a look at a real example here on my screen. We’re back here on my screen, and all I’ve done here is go to charts which are a great website, ycharts.com and typed in the QQQ which is the PowerShares. It follows the NASDAQ.

It’s a NASDAQ ETF. And what I’ve done here is I’ve put in the QID which is the ultra-short and then the QLD which is the ultra-long of the Qs. I’m just doing the same portfolio that we had assumed before, same thing, three different portfolios, an index, an ultra-short, ultra-long, etcetera.

And I’ve put the returns on here for the last five years, and you can see that the orange is the index. It is the Qs or the QQQ. The blue here is the QID which is the ultra-short, and then the red here is the QLD which is the ultra-long of the Qs.

After all this time, after five years, you can see we obviously had a good return spike in the QID which is the ultra-short during the market crash of 2000-2009.

Absolutely, shows the advantages of having these in your portfolio if you are going to use them for short-term hedging or for short-term directional plays that you’re going to speculate on.

And you can see that as the markets were falling, these went up almost nearly 100% at one point. But over the long run, you can see here that after five years that the index is still far outperforming both of these leveraged ETFs.

And what’s funny here is that actually, it’s outperforming the QLD which is the ultra-long ETF. Now, wasn’t that funny? The index is supposed to be up 28% over the last five years, but the QLD should be up more than that, double what the index is up, but it's not.

And this is where that pricing differential comes in. It’s adjusted on a daily basis. This daily change in the markets has a negative impact over the long run. And the longer this goes, the more the negative impact it’s going to have.

And you can see that the QID has already decayed tremendously. It’s down about 77% over the last five years. This drives home the point. And this is a live example. This is data taken from tonight when I just went in here.

I just put in some data for November 2011, the last five years and ran the numbers for returns. It's really interesting. As always, I want to point out these different kinds of risks. I think a lot of people get confused when they start talking about inverse ETFs.

They get excited about buying some of these inverse ETFs and then profiting whenever the market drops, but that’s not the case as we’ve seen here. Use them wisely. Know what the risks are.

As always, there is good and bad to both. There are advantages and disadvantages to both. I’m not saying one is better than the other, but this drives home the point of the pricing differential between these leveraged ETFs.