An inverse ETF is an exchange-traded fund (ETF) constructed using various derivatives to profit from a decline in the value of an underlying benchmark. Investing in inverse ETFs is similar to holding various short positions, involving borrowing securities and selling them with the hope of repurchasing at a lower price.
Inverse ETFs are also known as “Short ETFs” or “Bear ETFs.”
Key Takeaways
- An inverse ETF is built to profit from the decline of an underlying benchmark using derivatives.
- Inverse ETFs allow investors to make money when markets or indices decline without selling short.
- Higher management fees are common compared to traditional ETFs.
- Inverse ETFs are crafted for short holding periods.
Unlocking the Mechanics of Inverse ETFs
Many inverse ETFs utilize daily futures contracts to generate returns. A futures contract is a commitment to buy or sell an asset at a specific time and price, enabling investors to predict the asset’s price direction.
With their use of derivatives like futures, inverse ETFs allow investors to bet on market declines. If the market falls, the inverse ETF generally rises by a proportionate amount, minus fees and commissions.
Inverse ETFs are not designed as long-term investments. The frequent trading of derivative contracts by fund managers means that long-term performance will not mimic the benchmark fully. The frequent trading also accumulates higher expenses, with some inverse ETFs carrying expense ratios of over 1%.
Pros and Cons of Inverse ETFs
Pros:
- Enable profit-making when the underlying index declines.
- Useful tools for hedging investment portfolios.
- Available for major market indices.
Cons:
- Possibility of rapid losses if the market trend prediction is incorrect.
- Losses are compounded if held beyond one day.
- Typically higher fees than traditional ETFs.
Navigating Inverse ETFs vs. Short Selling
One major advantage of inverse ETFs is that they do not require a margin account. Margin accounts, necessary for short selling, involve borrowing funds from brokers, adding another layer of complexity and risk.
Short sellers do not own the securities they sell, intending to buy them back at a lower price. However, if the price rises, they face losses. Associated fees, such as stock loan fees, add to the complexity and cost. Conversely, inverse ETFs usually have expense ratios below 2% and are more accessible for investors with standard brokerage accounts.
Types of Inverse ETFs
Inverse ETFs are available for broad market indexes like the Russell 2000 and the Nasdaq 100. Additionally, there are inverse ETFs focusing on specific sectors such as financials, energy, or consumer staples. These funds are useful for both speculative profit and hedging against downturns.
Double and Triple Inverse ETFs
Leveraged inverse ETFs further magnify returns compared to standard inverse ETFs. For instance, a 2X-leveraged inverse ETF aims to deliver approximately a 4% positive return if the benchmark declines by 2% in a day.
Real-World Example: Inverse ETF in Action
ProShares Short S&P 500 (SH) provides inverse exposure to S&P 500 firms. With a 0.88% expense ratio and around $1.93 billion in assets as of Q4 2023, it’s geared for day-to-day tactical trade.
For example, on Nov. 2, 2023, the S&P rose by 1.07%, causing the SH ETF to drop 1.07% from $14.88 to $14.72. Investors holding SH on that day would have experienced losses.
How Do Inverse ETFs Work?
Inverse ETFs deploy derivatives like futures, swaps, and options to establish short positions in the underlying index. These ETFs rebalance daily to maintain the inverse market relationship.
Motivations for Inverse ETFs
Traders might use these ETFs either for speculative short-term gains from market declines or as a hedge against downturns.
Why are They Short-Term Instruments?
Inverse ETFs renew daily, diverging from inverse performance over long periods. They can compound losses in volatile, rising markets. Thus, they are designed for active traders, not long-term investors.
Bottom Line
Inverse ETFs aim to track inverse movements of benchmarks using derivatives like futures and options contracts. While suitable for short-term trades, these are complex instruments and should be handled cautiously. They present substantial risks for retail investors not planning to monitor the market actively.
Related Terms: Futures Contracts, Derivatives, Short Selling, Margin Account, Expense Ratios.
References
- Financial Industry Regulatory Authority. “The Lowdown on Leveraged and Inverse Exchange-Traded Products”.
- VettaFi. “Inverse ETF List: ETF Expenses”.
- Financial Industry Regulatory Authority. “Brokerage Accounts: Overview”.
- ETF.com. “SH”.
- YCharts. “ProShares Short S&P500 (SH)”.
