What Are Inverse ETFs?

Inverse exchange-traded funds (ETFs) are used as a short-term trading strategy to earn returns from a decrease in the value of their underlying market index or benchmark. Traders using inverse ETFs are bearish on particular stocks or industries and tend to use them as a hedge.

Holding inverse ETFs enables traders to profit from falling prices without shorting assets. Benzinga delves deep into inverse ETFs, explaining what they are, how traders can use them to their advantage and the drawbacks of holding inverse ETFs.

Inverse ETFs Defined

An inverse ETF provides investors with returns when the value of its underlying index decreases and the market declines. Think of inverse ETFs as opening a short position except that you earn profits when the ETF increases in value, which happens when the index that it tracks loses value.

These funds use a futures contract — an agreement to buy or sell an asset at a specific price and time — to speculate on the market losing value. If it does, the inverse ETF’s value increases by approximately the same percentage that the market falls, excluding broker fees and commissions.

One of the downsides of trading inverse ETFs is high fees. That’s because these funds are actively managed and sold daily. Investing in a standard index requires less trading, enabling investors to incur low fees. The high-frequency trading associated with inverse ETFs results in investors incurring a high expense ratio.

Because of its short-term position, an inverse ETF will likely not provide the same returns as the index that it tracks.

Trading an inverse ETF is similar to opening a short position. But a few differences exist between inverse ETFs and short positions.

Leveraged Inverse ETFs

Traders can use leveraged inverse ETFs to potentially increase their returns. The returns or losses an inverse ETF makes are usually equivalent to the movement in the tracked index. A leveraged ETF magnifies the returns or losses of the underlying index by two or three times.

Advantages of Buying Inverse ETFs

Investors who buy inverse ETFs enjoy several benefits that regular ETFs cannot provide because of the way inverse ETFs are structured.

No Margin Account

To profit from falling asset prices by shorting stocks, you need a margin account. It’s required for borrowing securities from a broker that you need to return later. Some margin accounts also incur fees for borrowing. You don’t incur fees for buying ETFs, and you don’t need a margin account because you’re not borrowing stocks.

Hedging

If you expect falling stock prices to decrease your portfolio’s value, you can protect it against market down moves by buying an inverse ETF, which will increase as the stocks fall.

Limited Losses

Prices can rise after you open a short position in a standard ETF, forcing you potentially to buy back the asset at much higher prices. That could result in huge losses. With an inverse ETF, your losses are limited to your original investment.

Drawbacks of Buying Into Inverse ETFs

Much like all investments, inverse ETFs are risky and contain drawbacks that investors need to consider before opening positions.

High Expense Ratio

Inverse ETFs are short-term positions that usually last less than a day. Because they’re actively managed, they have high expense ratios. You may pay up to a 1% expense ratio for a high-frequency traded fund.

Highly Risky

Profiting from an inverse ETF requires traders to possess advanced skills. Timing is crucial. Investors need to know when to enter a position and when to lock in profits. That requires you to monitor the prices throughout the day as volatility can cause price reversals and result in unfavorable trades.

Time-Sensitive

A standard ETF account can provide returns within a year, whereas inverse ETFs can provide large losses if held for more than one day.

Inverse ETFs vs. Short Selling

Traders wanting to profit from an asset losing value can short a stock. Since they don’t own the securities they want to trade, it’s necessary to borrow them from a broker. After borrowing the securities, the investor sells them on the open market but has to return them to the broker.

The only way to make a profit is for the investor to buy the securities at a lower price after selling them and then return them to the broker. If the price of the sold securities rises, the investor will eventually be forced to buy them at a higher price than the one sold, resulting in a loss.

The difference with inverse ETFs is that you’re not required to borrow securities from a broker because it uses futures, swaps and other derivatives. Shorting a stock with a broker usually requires you to pay a fee for borrowing the shares, whereas a buying fee is not applicable to inverse ETFs.

Investors cannot short an individual retirement account (IRA) because they don’t allow margin loans. Profiting from a decrease in IRA’s value is possible with an inverse ETF.

Common Hedge for Bears

Inverse ETFs offer a short-term trading strategy or investment objective to profit from the decrease in value of an index without shorting assets. They are commonly used as a hedge by bearish traders, but have drawbacks such as high expense ratios and high risk. Careful consideration and understanding are important for successful trading with inverse ETFs.

Compare ETF Brokers

Holding inverse ETFs is risky enough, and traders need to minimize their risk by opening positions with reliable brokers. Benzinga compiled a list of brokers enabling you to trade inverse ETFs safely.

Frequently Asked Questions