An inverse ETF, or short ETF, is a portfolio of securities that allows investors to make a bet that either the broader markets or a particular asset class or market sector will go down in the short term.
There are a wide range of inverse ETFs to choose from. There are dozens that are traded on U.S. markets. They allow investors to make short-term investments in the likelihood that the price of a given asset will go down. Investors can use inverse ETFs to seek returns when there are price dips in equities, fixed-income securities, and certain commodities. They do reset daily, however, and generally, investors may not want to hold onto them longer than a day.
Key Points
• An inverse ETF is a portfolio of securities designed to profit from market declines.
• Inverse ETFs trade on exchanges, similar to stocks.
• These ETFs use futures contracts to attempt to achieve the opposite result of an underlying index or benchmark.
• Leveraged inverse ETFs offer the potential for amplified returns, but also come with substantial risk.
• Investors use inverse ETFs to hedge against market drops or bet on short-term declines, but they do reset daily, adding another dimension of risk to a portfolio.
How Does an Inverse ETF Work?
To understand inverse ETFs, an investor first needs to know about Exchange Traded Funds (ETFs). An ETF is a portfolio of stocks, bonds, or other securities that trades on an exchange, like a stock. Its share price fluctuates throughout the day, as investors buy and sell shares of the fund.
As with regular ETFs, investors can buy and sell inverse ETFs throughout the day. Unlike the way ETFs work, however, inverse ETFs are designed not to invest in a given index, but to deliver the opposite result. If the index goes down, the inverse ETF should go up, and vice versa.
Leveraged & inverse ETPs (like ETNs) may be good for short-term trading. If you’re holding them long-term, watch for unexpected market changes and tracking errors. As noted, they reset daily, so there are risks involved with holding them longer than that.
What Do Inverse ETFs Invest In?
Inverse ETFs, or short ETFs, use complex trading strategies, involving a heavy use of futures contracts, to deliver the opposite result of the markets. Futures contracts are essentially agreements to buy or sell a given asset at a given date and price, regardless of the market price at the time. Using futures contracts, an investor can bet that a given asset, like a stock, will go up or down, without actually owning that asset.
Put simply, investors who think the price of a given stock will go down may buy a futures contract that allows them to sell a stock at a higher price than they think it will trade at by the expiration of the contract. If the price of that stock does go down, they can buy it on the open market cheaply and sell it to the other person or institution at the agreed-upon higher price, and pocket the difference.
An inverse ETF does that with a group of stocks, every trading day. The largest inverse ETFs aim to deliver the opposite returns of major stock indexes, like the Nasdaq or the S&P 500. For example, if the S&P 500 goes down 1% on a given day, then a corresponding inverse ETF could be designed to go up 1% that day.
Leveraged Inverse ETFs
There are other inverse ETFs that take the formula one step further, using leverage. That means they buy the futures contracts in their portfolios partially with borrowed money. That gives them the ability to offer outsized returns — two and three times the opposite of the day’s return — but it also exposes them to sizable single-day losses, and larger losses over time.
For example, on that same hypothetical day when the S&P 500 goes down 1%, the corresponding inverse ETF could be designed to go up by 2%.
Who Invests in Inverse ETFs?
An inverse ETF might seem like a good choice for an investor who is generally pessimistic about the prospects for the broader markets over the next few months or years. But that’s not necessarily the case.
Inverse ETFs only invest in one-day futures contracts. The futures contracts they invest in expire at the end of the trading day, locking in the ETFs’ gains and losses.
With an inverse ETF, it’s not enough to be right about the general direction of a given market, asset class, or sector. The performance of inverse ETFs isn’t the exact opposite of the index it tracks over longer periods of time. So, the investor has to be correct on the right days, as well.
Inverse ETFs get a lot of attention in the media during market swoons, when they post eye-popping returns. But most financial professionals probably don’t recommend them as long-term investments. They’re generally best for sophisticated investors with a high tolerance for risk.
What Are the Risks of Inverse ETFs?
Investors who purchase inverse ETFs take on risks that are common to all investors, and also some that are unique to this specific investment vehicle.
• Loss: If an investor buys an inverse ETF and the index that it tracks goes up, then the investor will lose money. If the given index goes up by 1% that day, then the fund offering the inverse of that index will go down by 1%; with a leveraged ETF, it could even go down by 2% or 3%.
• Fees: While most ETFs have very low management fees, inverse ETFs may have higher fees, which may take a bite out of returns over time. (It’s worth noting that the management fee can be typically lower than the time and expense of shorting the stocks directly.)
• Taxes: Inverse ETFs may be less tax efficient than other types of ETFs due to the fact that they reset daily. There could also be other tax-related issues to be aware of, so it may be a good idea to speak with a tax professional to learn more.
The risks are significant enough that, in 2019, the Securities and Exchange Commission proposed new regulations about inverse ETFs, requiring companies that manage leveraged and inverse ETFs to specifically make sure customers understood those risks. The regulation was not approved, which means the onus is still very much on investors to understand the risk.
Additionally, in 2022, regulators released a notice to investors about the risks of holding on to inverse and leveraged ETFs for longer than a day, saying that doing so could result in substantial and sudden losses.
The Takeaway
Inverse ETFs are designed as a tool to allow investors to bet against the market, or specific asset classes. While they come with unique risks, inverse ETFs may help investors seek returns on a given day during market dips, giving them the chance to short the market with one trade. These ETFs go up as the index goes down, offering an opportunity to generate returns when the market is trending down.
The trick: choosing the right inverse ETF on the right day, in order to gain rather than lose. The funds are risky, but can be popular among investors who want to hedge their exposure to a given asset class or market sector, and investors who believe that a given market is due for a big drop.
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FAQ
How does an inverse ETF work?
Inverse ETFs utilize complex trading strategies to deliver the opposite results of the markets. So, if an ETF attempts to mirror the results of the market, an inverse ETF attempts to do the opposite, and can be used as a shorting mechanism.
How often do inverse ETFs reset?
Inverse ETFs reset daily, and as such, are meant to be a short-term trading tool. Holding on to inverse ETFs for longer than a day can introduce significant risk to a portfolio.
What are the risks of inverse ETFs?
The primary risks associated with inverse ETFs are the risks of losses, and more complex tax implications. There may also be management fees that investors should be aware of.
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