March 12, 2025: Analysis of Leveraged Inverse ETFs in Economic Downturn Scenarios

The idea of leveraged inverse ETFs (exchange-traded funds) reaching their high prices from 2008-2009 due to current economic challenges is an interesting but complicated topic.

Leveraged inverse ETFs are special financial tools created to provide larger opposite returns compared to the indices or sectors they follow on a daily basis. These funds were highly valued during the Great Recession, but their prices have dropped significantly since then.

To understand why these products have changed, it’s important to look at how they work, their past performances, and the specific market conditions that would be needed for them to regain their former prices.

However, it seems unlikely that this will happen, even if economic conditions seem good for those betting against the market.

The Structural Reality of Leveraged Inverse ETFs

Leveraged inverse ETFs use complex financial tools that set them apart from traditional investments. These products rely on derivatives like swaps, futures contracts, and options to provide a multiple (usually 2x or 3x) of the opposite daily performance of their benchmark.

This focus on daily performance instead of long-term results significantly affects their value over time, no matter the economic situation.

The daily reset mechanism is a key part of how these products work. Each trading day, leveraged inverse ETFs adjust their portfolios to keep their target leverage ratio based on the current market value.

This means they increase their investment after market drops and decrease it after market rises.

Research shows that “leveraged ETFs respond to gains by increasing exposure to the benchmark index, and respond to losses by decreasing exposure each day.”

This process leads to something called “volatility drag” or “beta slippage,” which can lower value over time, especially in unstable markets without a clear direction.

The effects of this daily adjustment can lead to surprising outcomes that may confuse investors. For example, if a regular index goes through ups and downs but ends up the same, an investor in that index would break even.

However, a leveraged inverse ETF that follows that same index could actually lose value during that time.

Academic research explains that “a continued pattern of this sort will typically cause the decay of the longer term returns of the fund.”

This means that even in situations where it seems these products should perform well, they might not give the expected returns over longer periods.

Historical Price Erosion and Reverse Splits

The significant price difference between the 2008-2009 valuations of these ETFs and their current prices is not fully clear without considering reverse stock splits.

These actions have been essential for keeping leveraged inverse ETFs viable, even though they tend to lose value over time. Financial literature notes that “not all leveraged and inverse ETPs that trend toward nothingness necessarily de-list and close.

Some have used reverse share splits—exchanging multiple lower priced shares for a new, single share with a higher price—to prolong their existence”¹.

The number of reverse splits shows the problems these investment products have.

Data shows that “of the over 600 leveraged or inverse ETPs that launched in the United States since 2006, over 40% have liquidated”¹. This is much higher than the closure rates of regular ETFs and highlights the difficulties these products have in staying viable over time.

The ones that are still around often went through several reverse splits to keep their share prices somewhat reasonable while their actual value to investors continued to decline.

For example, the ETFs ProShares UltraShort MidCap400 (MZZ), Direxion Daily S&P 500 Bear 3X Shares (SPXS), and Direxion Daily Financial Bear 3X Shares (FAZ) have all had this happen.

“Direxion Daily S&P 500 Bear 3X Shares (SPXS) has lost 99.98% of its value, through many reverse splits”¹.

This explains how a product that was once worth $45,000 per share can now be priced below $15 without disappearing completely. Each reverse split made the share price look higher, but investors still lost value in their investments.

Performance During Economic Downturns

Historical evidence shows that leveraged inverse ETFs can make big short-term gains during market crises. For example, during the 2008-2009 financial crisis, some inverse funds saw major profits.

One case highlighted that if an investor bought $100 of one such fund in 2007, it would have grown to $340 as the market fell apart. Recently, during the COVID-19 crash, certain inverse ETFs also gained significant value.

These products clearly have the potential to offer strong short-term results when the economy is struggling. Data from late 2024 indicated that many inverse ETFs had considerable weekly returns during market stress, especially those focused on areas like semiconductors, biotech, and small companies, with gains of 20-30% in just one week. These sharp movements show how these funds can respond quickly to negative market situations.

However, the historical record also reveals some downsides to these short-term gains. For instance, the same inverse ETF that rose to $340 during the financial crisis ended up dropping to just $7.61 when it closed in 2015.

This trend highlights an important fact: while these products can do well in times of severe market stress, they aren’t built to maintain those profits over a long period, no matter the economic situation.

Recession and Stagflation Scenarios

The current economic situation has several factors that could cause instability, such as tariff policies, layoffs, and relaxed financial regulations. These factors may raise the chance of a recession or stagflation, each leading to different market behaviors that affect leveraged inverse ETFs.

In a recession, stock markets usually face heavy selling, and major indices might drop by 20-30% or more. History shows that inverse ETFs tend to do well in these situations, at least in the short run. During market downturns, many investors buy these products to protect themselves against falling prices.

As noted in one analysis, “investors can profit from a market correction or an economic recession by investing in inverse ETFs.” However, how much they gain and for how long depends on how bad and how long the market decline lasts.

Stagflation is trickier, as it combines slow economic growth with ongoing inflation. Research shows that certain sectors and assets perform better during stagflation. For example, a recent study on stagflation-resistant ETFs found that gold, silver, healthcare, consumer staples, utilities, short-term treasuries, and some commodities might be good investments.

Interestingly, general market inverse ETFs are not included in this list, which means they might not perform well during stagflation.

Financial research warns that even in good market conditions, leveraged inverse ETFs face big challenges.

One study points out that while there can be some diversification benefits based on how equity and debt markets perform, these need to be compared with the known difficulties of holding them for a long time.

Most financial experts agree that these products are “primarily used as short-term investment strategies by experienced traders who understand the risks involved.”

Mathematical Impediments to Value Recovery

The chances of leveraged inverse ETFs returning to their prices from 2008-2009 face many challenges. First, since the financial crisis, major stock markets have risen significantly, which works against these ETFs.

Since 2009, the main stock indices have gained huge percentages, while these ETFs, which are designed to go in the opposite direction, have declined due to this leverage.

Additionally, the daily adjustments these ETFs make create a mathematical issue where you can’t just reverse the effects, even if the market falls sharply like it did during the crisis.

As financial experts state, “when the underlying index gains 16.63%, SPXS declined by 37.4%.” This means if the market dropped by 16.63%, SPXS wouldn’t necessarily rise by 37.4% because of how it’s been affected in the past.

For these ETFs to return to their previous high values, not only would there need to be a market crash, but it would take an extraordinary mathematical change. For example, FAZ was about $1.6 million per share in 2009. To get back there from its current price of less than $15 would need an unrealistically high percentage increase, even in a very severe economic downturn.

Research supports this idea: “inverse funds face unique challenges when they try to provide inverse returns on indexes that have tended to rise over time.” This basic challenge means that the longer these ETFs operate in rising markets, the harder it becomes for them to regain their earlier values.

Conclusion: Realistic Expectations for Leveraged Inverse ETFs

The possibility of leveraged inverse ETFs returning to their price levels from 2008-2009 during a recession or stagflation needs careful consideration. While these ETFs might offer short-term chances during economic downturns, their design makes it nearly impossible for them to recover to past highs in the long run.

Here are a few important reasons why this is the case:

Daily Rebalancing: The way these ETFs are set up means that they lose value over time, and market changes in the opposite direction won’t fix this decay.
Reverse Splits: Many of these products have had multiple reverse splits, which means their current shares are worth much less than their 2008-2009 versions.
Bull Market Since 2009: The strong market since 2009 has driven these ETFs far from their former values, so even a big market crash wouldn’t be enough to close the gap.

For those looking to protect their investments during tough economic times, experts recommend seeing leveraged inverse ETFs as short-term tools instead of long-term investments. One analysis describes these products as “designed for speculative traders and investors seeking tactical day trades against their respective underlying indexes.” Investors worried about a recession or stagflation may want to explore other safer options, like gold, short-term treasuries, consumer staples, and utilities.

In summary, while leveraged inverse ETFs might show significant short-term gains during market stress, their design and structure make it nearly impossible for them to reach their values from the financial crisis again. It’s crucial for investors to understand these limitations when considering these products in response to changing economic conditions.

Citations:

Answer from Perplexity: pplx.ai/share