Inverse ETFs employ various techniques to get the correct market exposure. In many cases they include derivatives like futures, options, and swaps.
The main concern in derivatives is “counterparty risk.” These instruments are nothing more than legal agreements in which two parties agree to do specific things in specific circumstances. One party is you — or really the ETF manager, acting on your behalf.
In the case of an inverse ETF, the counterparty agrees to pay your ETF if the selected benchmark goes down. Likewise, the ETF will pay the counterparty if the selected benchmark goes up. Counterparty risk is the possibility the other side won’t make good on their bet.
Most inverse ETFs achieve their desired exposure by holding swaps. And it is important to note here, that swaps typically involve only the gains and losses in an index, not the base value of the index itself.
For example, if an index has a starting value of 100 and moves 2 percent, the swap only covers the 2 percent move (4 percent if it happens to be a 2x fund).
If the counterparty were to default, the ETF might not be able to collect on the 2 percent or 4 percent gain, but it would still have the initial cash representing the original index value of 100. This example is oversimplified of course, but I think you get the idea.
Counterparty risk is everywhere.
Counterparty risk isn’t unique to derivatives contracts. When you buy a plane ticket, for instance, you agree to give the airline a certain amount of money. They agree to have a seat available for you on a plane going to your destination at a defined date and time.
If you don’t pay for your ticket, or the plane takes you to the wrong city, then it is a form of “counterparty default.”
Defaults on equity swaps are very rare, but there is always the possibility that it could happen. This is one factor to consider when deciding whether an inverse ETF is what you need.
Every ETF has a prospectus with detailed information on its characteristics, fees, and risks. Always read it before you invest a dime. You can find it on the sponsor’s website. If you don’t understand something, get clarification from a reliable source.
from Ron Rowland --Three often overlooked risks of Inverse ETFs
I note that BEARX holds about 50% of their investments as futures.