Inverse exchange traded funds, or bearish ETFs, allow investors to profit from downward moves in select indexes or sectors without directly shorting stocks. A reverse stock split would appear to hurt inverse ETFs, because reverse splits inflate the price of the stock undergoing the split. However, the adverse impact of reverse splits on inverse ETFs is negligible, for a few reasons.
No Increase in Value
Here is how a reverse split works. You own 1,000 shares of XYZ Corp. at $10 and the company announces a 2-for-1 reverse split. That means you now own 500 shares of XYZ worth $20 apiece. There is no decrease in the value of your position. Likewise, there is no increase in market value of XYZ. The share price did not rise through normal price appreciation. So an inverse ETF that would be vulnerable to a potential increase in XYZ’s market value is not vulnerable in a reverse-split scenario.
Reverse Splits Don't Always Work
In theory, reverse splits are an aesthetic change. Companies make reverse splits hoping for a higher share price that would increase allure among investors. That isn't always the case. In fact, many stocks that are reverse-split continue falling after the split. Take Citigroup, which underwent a 1-for-10 reverse split in May 2011. After the split, the shares traded around $45. By October 2011, that stock had lost almost half of its value. That would have worked in favor of any inverse ETF with Citigroup exposure.
Even if The Reverse Split Works ...
Assume for a moment that a reverse split has the desired effect and the shares move higher post-split. This would be bad news for an inverse ETF only if the index that the inverse ETF tracked held a significant weight of the split stock. Take the example of the ProShares Short Financials, designed to deliver an inverse daily performance of the Dow Jones U.S. Financials Index. That index has some exposure to Citigroup, but not so much that the short financials ETF would have been vulnerable even if Citi had surged after its reverse split. If Citi had accounted for 20 pecent of that index, the story would have been much different.
Most Reverse Splits Don't Hurt Inverse ETFs
The bottom line is that the majority of reverse splits do not adversely affect inverse ETFs. Stocks sometimes move lower after reverse splits, and that helps the inverse ETF.
Todd Shriber is a financial writer who started covering financial markets in 2000. He worked for three years with Bloomberg News and specializes in analysis of stocks, sectors and exchange-traded funds. Shriber has a Bachelor of Science in broadcast journalism from Texas Christian University.