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What are Inverse ETFs?

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What are Inverse ETFs?

Inverse ETFs are exchange traded funds designed to return the inverse of the daily return for an index. In other words, when the index loses value, the fund gains value – and vice versa, if the index gains value the fund will lose value.

Inverse ETFs, also known as short ETFs or bear ETFs, are designed to capture the inverse daily returns, rather than inverse long-term returns. They can be used to hedge a portfolio for short periods of time or to speculate on falling prices.

ETFs vs ETNs

Exchange traded funds (ETFs) and exchange traded notes (ETNs) are very similar products. They are often used interchangeably and serve the same function. However, there is an important distinction. Some of the inverse products that are widely traded are actually ETNs, so it is worth understanding the difference.

An ETF is a trust which owns a portfolio of assets. ETFs are designed to track an index, but their value is actually determined by the value of the assets held by the trust. This means there may be a small difference between the performance of the fund and the index it tracks, known as tracking error.

By contrast, an ETN, is actually a type of unsecured debt security. It has a maturity date, at which point the issuer will pay the holder the initial capital plus or minus the return of an index. An ETN does not represent ownership of any assets. Instead, the product is backed by the issuer.

ETNs are well suited to situations where a traditional portfolio of assets is difficult or expensive to create. On the other hand, they introduce counterparty risk to the product.

Leveraged inverse ETFs

Many of the most widely traded inverse ETFs provide leverage in addition to inverse returns. In other words, a 3X inverse ETF would rise 3 percent in value if the index fell 1%.

This is a useful attribute as it reduces the additional capital required to hedge a portfolio. Let’s say you have long positions worth $100,000. To hedge this portfolio by buying an unleveraged fund, you would need another $100,000. If you instead buy a leveraged inverse ETF with 3X leverage, you will only need $33,000.

We have covered leveraged ETFs in more detail here.

Alternative Ways to Short the Market

Whether you want to hedge a portfolio of long positions, or you want to speculate on an index declining, inverse ETFs are one of the easiest methods available to the average investor. But there are a few other approaches worth knowing about.

Short selling shares entails borrowing shares from another investor (for which a fee is paid) and then selling those shares. When the shares are repurchased, they are returned to the lender. Short selling shares requires a special type of trading account.

You can also short sell derivatives like futures contracts or CFDs (contracts for difference). This is more straightforward as no borrowing is involved – however, you will need a derivative trading account.

Finally, you can buy put options on the asset you want to hedge. A put option gives you the right to sell the asset at a specific price. If the price of the asset does fall, you can either sell the asset at the higher price or simply sell the option which will have gained in value. Options trading also requires a derivative trading account.

Examples of Inverse ETFs

The universe of inverse ETFs is dominated by a handful of issuers, with ProShares and Direxion accounting for most US-listed funds.

The largest inverse fund is the ProShares Short S&P 500 ETF (SH). This product is designed to return the inverse daily return for the S&P500 index and has an expense ratio of 0.89%.

Investors wanting to short an index of small-cap stocks can buy the ProShares Short Russell 2000 fund (RWM). This fund is structured to return the inverse daily returns for the well known Russell 2000 small-cap index.

The ProShares UltraPro Short ETF (SQQQ) is a useful product for shorting the Nasdaq 100 with 3X leverage. A similar fund with more focus is the MicroSectors FANG+ Index 3X Inverse Leveraged ETN (FNGD) which aims to return three times the inverse return of an index of 10 large, widely traded tech stocks. The index includes the popular FANG stocks, Facebook, Apple, Netflix, and Google.

Inverse ETFs are also available for other sectors and industries. For example, the ProShares UltraShort Real Estate fund (SRS) is based on the Dow Jones U.S. Real Estate Index and employs 2X leverage.

Bond investors wanting to hedge exposure or speculate on rising rates can buy the Ultrashort Barclays 20+ Year Treasury ETF (TBT). This fund focuses on longer-dated bonds and is 2X leveraged.

Similar ETFs can be used to hedge the prices of commodities like oil, gas, silver, and gold. The ProShares UltraShort Bloomberg Crude Oil fund (SCO) is the most popular fund in this category. It is 2X leveraged and the expense ratio is 0.95%.

A slightly different type of inverse ETF is the AdvisorShares Ranger Equity Bear ETF (HDGE). This fund is actively managed using quantitative trading strategies – however it comes at a cost of 3.12% a year.

Advantages of Inverse ETFs

  • Inverse ETFs are very useful for reducing risk ahead of important economic releases and announcements.
  • Inverse ETFs can also be used to profit from declines in most liquid markets and indexes.
  • ETFs are the easiest way to open a short position as you do not need to borrow shares or open a derivative trading account.

Disadvantages of Inverse ETFs

  • Inverse ETFs can expose your portfolio to many of the same risks as leveraged ETFs. Negative returns can compound very quickly, eroding the NAV of an ETF in the process.
  • Positions need to be carefully managed and overnight positions should be limited. If a reversal occurs after the market closes, you will not be able to close your position until the market opens the following day.
  • Inverse ETFs have significantly higher management fees than regular ETFs.

Conclusion

Like leveraged ETFs, inverse ETFs are useful for short term speculation and hedging. But they should also be approached with caution as they are more sophisticated than regular ETFs, and introduce new risks to the investing process.

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Richard Bowman is a writer, analyst and investor based in Cape Town, South Africa. He has over 18 years’ experience in asset management, stockbroking, financial media and systematic trading. Richard combines fundamental, quantitative and technical analysis with a dash of common sense.

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