Inverse ETFs Revisited: A Case for Regulatory Reassessment by SEBI

[By Hemant Tewari & Apoorva Singh Rathaur]

The authors are students of Dharmashastra National Law University, Jabalpur.

 

Introduction

Exchange Traded Funds (ETFs) stand as mutual fund instruments affording access to an index or a collection of securities, trading on exchanges akin to individual stocks. Investors can seamlessly trade ETF units at prevailing market prices, enjoying exposure to distinct sectors, styles, asset categories, industries, or nations. ETFs offer cost efficiency surpassing conventional open-end funds, coupled with trading flexibility, diversification, and heightened transparency.

The buy-and-forget strategy is often forced down retail investors’ throats with all finfluencers standing mighty behind it. As a retail investor, one can buy instruments like mutual funds and ETFs and only hope helplessly that their value increases. But retail investors are left without options when they would want to hedge their portfolios or short-sell securities. Derivatives like futures, options, and short-selling are risky and expensive ways of facilitating your bearish ambitions. On such occasions, Inverse ETFs become the harbinger of financial justice.

The goal of inverse exchange-traded funds is to produce returns that are the opposite of those of an underlying index or benchmark. Inverse ETFs use financial derivatives like futures contracts to achieve their inverse performance. They are cheaper as compared to traditional shorting of stocks and using derivatives, with no need of maintaining a margin account or pay a stock loan fee. Daily churning is the norm with inverse ETFs and they are recommended for investors with a short-term view of the index.

Currently, Inverse ETFs are not allowed in India and are regulated by SEBI. Introducing inverse ETFs would provide a wider range of financial products to retail investors and can facilitate the development of the market. It would also improve the ease of doing business without compromising the basic tenets of investor protection and risk mitigation in the market ecosystem.

Present Standings

In India, the first ETF, called Nifty BeEs, was launched in 2002 by Benchmark MF. The ETF industry has matured since then, the number of passive mutual fund schemes in March 2023 was 349, up from 229 in June 2022, representing a 52% increase with a net Asset under management(AUM) upwards of 5 lakh crores. It represents the growing trend of passive investors and the strength of the ETF market.

Benchmark MF had submitted a document proposing setting up India’s first Inverse ETF in 2004 but later withdrew the document after it was acquired by Reliance from Goldman Sachs. No such attempts have been made by any AMC since and Inverse ETFs were unable to garner any support from SEBI or any AMC.

The Indian Regulator does not allow Inverse ETFs in India. However, the National Stock Exchange(NSE) has two Inverse indices that the AMCs or retail investors can track-

  1. NIFTY50 PR 1x Inverse Index
  2. NIFTY50 TR 1x Inverse Index

Inverse ETFs that track these Indian indices do exist. They are however listed in foreign jurisdictions and not in India. Fubon Asset Management, located in Taiwan, launched the Nifty50 PR 1X Inverse ETF in October 2014. Similarly, in 2016, Hong Kong-based CSOP Asset Management created the CSOP Nifty 50 Daily (-1x) Inverse ETF.

Inverse ETFs have grown in developed markets with the introduction of leveraged inverse ETFs wherein a move in any direction in the index is inversely mirrored by 200% i.e. if the leverage is 2x. Recently, Horizons ETF became the first fund to release the Bitcoin inverse ETF called the BetaPro Inverse Bitcoin ETF (“BITI”) on the Toronto stock exchange. The Indian markets also welcomed for the first time, debt ETFs in the markets.

Internationally, there are Inverse ETFs for almost all the major global markets e.g. Europe (ProShares UltraShort FTSE Europe), China (Direxion Daily CSI 300 China A Share Bear 1X Shares), Japan (UltraShort MSCI Japan ProShares), Brazil (ProShares UltraShort MSCI Brazil), Emerging Markets (UltraShort MSCI Emerging Markets). There are Inverse ETFs for currencies as well like e.g. ProShares Short Euro (EUFX); which seeks to deliver minus 1x return of EUR over USD.

Such developments in developed and emerging markets signify a strong demand for Inverse tracking products and subsequently indicate the robustness of Inverse ETFs.

Benefits

Inverse index ETFs offer several compelling advantages:

  • Limited Risk: When investing in inverse index ETFs, the maximum potential loss is confined to the unit price of the ETF, similar to purchasing regular stocks. This is a significant improvement over alternative bearish strategies like shorting stocks or utilizing option strategies, both of which can lead to potentially unlimited losses. In this sense, using inverse index ETFs provides a more controlled risk environment.
  • Daily Profit Potential: Investors leveraging inverse index ETFs have the unique opportunity to profit from declining stock prices on a daily basis. This ability to benefit from short-term market movements provides a dynamic approach for capitalizing on bearish trends.
  • Cost-Effective Approach: Inverse index ETFs serve as a cost-effective means to express a bearish stance. Comparable to other exchange-traded funds, they typically maintain low expense ratios. This cost efficiency is particularly valuable for investors seeking to implement tactical strategies without incurring substantial fees.

For domestic investors, options for bearish strategies are limited. Shorting stock or index futures is risky. Buying index or stock put options can be easier, but timing the market is challenging due to time value. Additionally, less-traded options and the volatile volatility index are risky alternatives, especially during turbulent times.

Foreign Jurisdictions

A direct comparison with developed markets might not be the best comparative strategy but comparing Indian markets to such jurisdictions where the markets are somewhat similar in size and socio-political context might help.

For example, in Asia, countries like Japan, South Korea, Taiwan, and Hong Kong, have Inverse ETF products where total assets in such instruments at the end of 2022 amounted to about $20bn. The first Inverse ETF in Asia was launched by Deutsche Bank on the Singapore stock exchange tracking the S&P500 index. Outside Asia, New Zealand, and France have allowed Inverse ETFs.

Maybank Asset Management is preparing to introduce Malaysia’s inaugural mutual fund that invests in an inverse exchange-traded fund (ETF) tracking the S&P 500, a move aimed at addressing investor concerns during challenging market periods. However, ETF adoption in the country has been low owing to poor investor education which has led Maybank Asset Management to stop in its tracks in order to rethink its marketing strategy.

ProShares Short Russell2000 and ProShares UltraPro Short QQQ, which track the NASDAQ 100 and Russell 2000 index, are listed in the United States and are widely considered to be the most prominent and used ETFs.

Conclusion

Several instructional campaigns and SEBI rule tightening have failed to discourage ordinary investors from entering the derivatives market. According to SEBI research published in January, nine out of ten individual traders, mostly in their 30s, lost money in the previous fiscal year, with average losses totalling over 110,000 Indian rupees. Inverse ETF can prove to be a solution to this problem when the markets are nearing all-time highs, it should deter retail investors from going through the derivatives market and investing in a relatively safer instrument, with a wider buffet of investment products, such as the Inverse ETF.

While the ETF landscape in India has flourished, the concept of Inverse ETFs remains largely unexplored due to regulatory constraints. As the Indian financial landscape continues to evolve and regulatory frameworks adapt, there can be opportunities for the emergence of Inverse ETFs in the domestic market. The journey of ETFs, from their inception in India to their global diversification and innovation, mirrors the broader transformation of investment landscapes worldwide. It’s about time SEBI takes inspiration from its global counterparts and considers embracing Inverse ETFs, allowing these innovative instruments a chance to flourish in the market.

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