Inverse ETFs: What They Are & How They Work
Inverse ETFs are designed to produce returns that are the opposite of an underlying benchmark index. Although these funds can be useful tools for investors, they carry unique risks.
What Is an Inverse ETF?
An inverse ETF is an exchange-traded fund that uses short selling, derivatives, futures, or other leveraging techniques to produce returns that are the inverse of a benchmark index. For example, an inverse ETF can enable an investor to get a positive return when the underlying index it is designed to track has a negative return.
How an Inverse ETF Works
An inverse ETF relies on derivatives, such as futures, to create a portfolio that is essentially short the underlying securities. The goal of the inverse ETF fund manager is to achieve daily returns that are the opposite, or inverse, a benchmark index, such as the S&P 500.
For example, if the S&P 500 index had a daily return of -1%, an inverse S&P 500 ETF should produce a return of approximately +1%. To achieve this inverse return, the fund manager may employ leveraging techniques and tools, such as short selling or the buying or selling of futures contracts.
Because their value rises when market prices are falling, inverse ETFs tend to be most popular in bear markets or when investor concerns are high. Since they use short sales as part of their strategy, an investor may be exposed to unlimited losses. For this reason, inverse ETFs are most effectively used by day traders and other short-term investors.
Warning: Inverse ETFs are typically used in a short-term trading strategy for market timing purposes. Because the derivatives used to accomplish the inverse return are bought and sold daily, inverse ETFs are not suitable for long-term investing.
Types of Inverse ETFs
There are many types of inverse ETFs designed to profit from losses in the market. Just as there are many types of traditional ETFs, there is a wide range of inverse ETFs that track various market indexes.
There are Inverse ETFs for a variety of asset types such as:
- Commodities: oil, natural gas, gold, silver, etc.
- Bonds: high yield, Treasury, etc.
- Currencies
There are also Inverse ETFs designed to profit from dips in:
- A particular market sector: financials, biotech, etc.
- The broader market: S&P 500, Russell 2000, Nasdaq 100
Alternatives to Inverse ETFs
Inverse Leveraged ETF
As alternatives to inverse ETFs, there are also inverse leveraged ETFs that are designed to amplify the inverse performance, such as a double or triple daily inverse return, of the benchmark index.
The difference between inverse ETFs and leveraged inverse ETFs is relatively subtle but easy to understand.
- An inverse ETF will produce a daily return that is 1:1 inverse to the benchmark index. For example, if the benchmark index falls 1%, the inverse ETF would rise 1%.
- With leveraged ETFs, there is usually a 2:1 or 3:1 inverse relationship. So, a 2:1 leveraged inverse ETF would rise 2% if the benchmark index fell 1%.
Short Selling Strategy
Investors may also choose to implement their own short selling strategy, which requires a margin account.
Pros & Cons of Inverse ETFs
Pros of Inverse ETFs
- Hedging: Investors can attempt to hedge their long positions with inverse ETFs, if they worry markets might decline but they don't want to sell their individual stocks.
- Alternative to derivatives: Inverse ETFs offer indirect access to financial derivatives, such as futures contracts, that may otherwise be expensive to trade or inaccessible to everyday investors.
- Easy access: Like traditional ETFs, shares of inverse ETFs trade in the open market like stocks. Investors may also use inverse ETFs in retirement accounts, which do not typically allow derivatives or short selling.
Cons of Inverse ETFs
- Higher fees: Due to daily active management and additional expenses associated with financial derivatives, inverse ETFs have higher fees compared to traditional ETFs.
- Long-term tracking error: Since inverse ETFs target the inverse of daily performance, long-term performance will not provide returns in equal measure.
- Daily tracking error: The strategies used within inverse ETFs may not result in precise inverse movements even on a daily basis.
Bottom Line
Inverse ETFs can be useful tools for short-term trading strategies but are not suitable for long-term investment use. Since inverse ETFs produce gains in a down market, some investors use them for hedging or market timing purposes. However, these ETFs carry additional risks compared to traditional ETFs.
This article was written by
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