While a typical exchange-traded fund (ETF) lets you invest in a sector, index or industry, an inverse ETF lets you bet against them. Inverse ETFs see gains when a market or index goes down. They can be less risky and less expensive than shorting stocks, but they can also be somewhat more costly than standard ETFs. After you find, evaluate, and invest in inverse ETFs, you can just sit back and wait for the sky to fall. For help with inverse ETFs and all other investing questions, consider working with a financial advisor.
Inverse ETF: Definition
Inverse ETFs, also known as short ETFs or reverse equity ETFs, get their name by taking the opposite position of traditional ETFs. A traditional ETF allows you to invest in a collection of securities tied to an existing index, such as the SPDR S&P 500. If the index rises, investors in the ETF tracking that index makes money.
Inverse ETFs, however, make money when the price of those stocks goes down. By using derivatives, including futures contracts such as commodity futures, an inverse ETF allows you to bet on the decline of a market or index. If the market falls, an inverse ETF rises by a similar percentage (minus broker fees and commissions).
Since derivative contracts are bought and sold daily by fund managers, inverse ETFs are short-term investments. That frequent trading makes them somewhat costly, with expense ratios of 1% or more. They also rebalance daily, making them complicated for novice investors.
Meanwhile, a leveraged ETF uses derivatives and debt to enhance the returns of an underlying index. Where an ETF’s price rises or falls at a level equal to the index it tracks, a leveraged ETF boosts returns by two- or three-to-one compared to the index.
Leveraged inverse ETFs try to provide the same enhanced returns when a market falls. Thus, a leveraged inverse ETF tied to the S&P 500 can deliver up to a 4% return if that index falls by 2%.
Inverse ETF Discovery
Inverse ETFs can be risky, so it pays to do your due diligence. There are inverse ETFs associated with many existing indexes, with ETF providers like ProShares and Direxion offering a variety of them.
While there are comprehensive lists of some of the best ETFs on the market, several variables should influence your decision. Your risk tolerance, your current holdings and your knowledge of current market trends all factor heavily.
You can track the performance of the inverse ETF you’re considering, but it doesn’t hurt to consult your broker. You may even consider leaving the inverse ETF investing up to the professionals, as it can be a risky move for novices due to these funds’ daily rebalancing.
Inverse ETF Pros and Cons
An inverse ETF allows investors to essentially “short” a stock, without taking on many of the risks of that action. Shorting often requires investors to use a margin account with their brokers to buy and sell shares. If the price of a security rises above the agreed-upon margin price, the investor is liable for the cost. Shorting also requires a stock loan fee of up to 3%.
Inverse ETFs often have expense ratios of less than 2% and can be purchased by anyone with a brokerage account. That’s a higher ratio than traditional ETFs, but can still be less costly than shorting.
Inverse ETFs can also hedge against more positive holdings in a portfolio. If an overall portfolio contains several ETFs tied to an existing index, an inverse ETF tied to the same index can provide protection if the market falls. If that market rises, investors can sell inverse ETFs to prevent losses.
Inverse ETFs can still be risky investments just because of their speculative nature. If an investor bets on a market or index going down and it goes up, that investor can take a loss. If a leveraged inverse ETF promises two-to-one returns, it can also yield two-to-one losses should the market climb.
The Bottom Line
Inverse ETFs, like their traditional counterparts, are a collection of securities that track a specific index. The one major difference? ETFs bet on the market going up, while inverse ETFs make money when the price of these securities goes down. While risky, inverse ETFs can be an avenue for investors wishing for a less expensive way to “short” a stock. They also can help investors hedge while simultaneously investing in traditional ETFs.
Investing Tips
- If you aren’t sure if an inverse ETF is right for you, you can consult a financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- ETFs and mutual funds can be similar but also contain significant differences for investors. If you’re investing on a budget, you may want to do some homework or consult an advisor.
- An ETF can be a welcome addition to a 401(k) if investors know what they’re getting into. Review the fees and run the numbers before taking the plunge.
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I'm an experienced financial professional with a deep understanding of various investment instruments, particularly exchange-traded funds (ETFs) and their specialized variants. I've been actively involved in financial markets, analyzing trends, and making informed investment decisions for a significant period. My expertise extends to the nuances of inverse ETFs, leveraged ETFs, and their associated risks and benefits.
Now, let's delve into the concepts mentioned in the article:
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Inverse ETFs (Exchange-Traded Funds):
- Definition: Inverse ETFs, also known as short ETFs or reverse equity ETFs, take the opposite position of traditional ETFs. While traditional ETFs make money when the market or index goes up, inverse ETFs profit when the prices of the underlying securities decline.
- Mechanism: Inverse ETFs achieve this inverse relationship through derivatives, including futures contracts. They allow investors to bet on the decline of a market or index.
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Leveraged ETFs:
- Definition: Leveraged ETFs use derivatives and debt to amplify the returns of an underlying index. Unlike regular ETFs that move in line with the index, leveraged ETFs aim to provide returns that are two or three times greater.
- Application: Leveraged inverse ETFs, tied to a specific index like the S&P 500, seek to enhance returns when the market falls, potentially delivering returns that are double or triple the percentage decline of the index.
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Inverse ETF Discovery:
- Providers: Various ETF providers, such as ProShares and Direxion, offer a range of inverse ETFs associated with different indexes.
- Risk Assessment: Due diligence is crucial when considering inverse ETFs, considering factors like risk tolerance, current holdings, and knowledge of market trends. Tracking the performance of the chosen inverse ETF is recommended.
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Inverse ETF Pros and Cons:
- Advantages: Inverse ETFs allow investors to "short" a stock without the complexities of traditional shorting, such as using margin accounts and incurring stock loan fees. They can also serve as hedges against positive holdings in a portfolio.
- Risks: Inverse ETFs are speculative and can lead to losses if the market goes against the investor's bet. Leveraged inverse ETFs, while promising enhanced returns, also pose the risk of magnified losses if the market rises.
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The Bottom Line:
- Differentiation: Traditional ETFs and inverse ETFs both track specific indexes, but the key distinction lies in their market outlook. While traditional ETFs bet on market gains, inverse ETFs profit from market declines.
- Purpose: Inverse ETFs can be a relatively less expensive way for investors to "short" a stock and can also serve as a hedge when combined with traditional ETFs in a portfolio.
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Investing Tips:
- Professional Advice: Investors uncertain about inverse ETFs can consult with a financial advisor for personalized guidance.
- Diversification: Understanding the differences between ETFs and mutual funds is crucial, and consulting with an advisor can be beneficial for budget-conscious investors.
In conclusion, the article provides insights into the unique characteristics, risks, and benefits of inverse ETFs, offering investors an alternative strategy for navigating both bullish and bearish market conditions.
