An inverse ETF (exchange-traded fund) is a type of ETF that rises when the underlying asset prices fall.
Contrarian traders who want to profit from the decrease in the value of an asset generally tend to use such instruments. Contrarian investing is the investment strategy of profiting from trading against the market direction.
For example, if the market is bearish, i.e., falling, the contrarian investor is bullish, i.e., expects growth, and hence will look for buying prospects.
Simply put, when the index ‘sees’ the ETF ‘saws.’ illustratively.
- Inverse ETFs are similar to short-leveraged ETFs but differ in the gearing ratio. The gearing ratio is the means of measuring financial leverage to equity. Inverse ETFs generally have a gearing ratio of 1, whereas short-leveraged ETFs can have a gearing ratio of 2 or 3.
- Short-leveraged ETF is ProShares UltraPro Short QQQ which provides a 3x daily short exposure on Nasdaq 100.
Inverse ETF is ProShares Short Russell2000 which provides a 1x daily short on the Russell 2000.
The inverse of an ETF is also called a short ETF or a Bear ETF
Like short-leveraged instruments, inverse ETFs also hold swaps to achieve their exposure. A short Russell 2000 will hold swaps paying the return to the counterparty.
If the index trades up, the fund will pay the return to the counterparty, decreasing the ETF value; otherwise, the index goes down.
The ETF rebalancing needs daily attention to achieve this kind of balance. Inverse ETFs are balanced daily; hence they are best suited as a short-term instrument.
In the long run, the ETF will exactly replicate the index; on the contrary, no guarantee of direction.
The illustration below helps us comprehend this with ease
| Days | Daily market performance | Expected index level | Expected 1x Inverse ETF level | Daily ETF performance |
| 0 | 0% | 100 | 100 | |
| 1 | -5% | 95.00 | 105.00 | 5% |
| 2 | -5% | 90.25 | 110.25 | 5% |
| 3 | -5% | 85.74 | 115.76 | 5% |
| 4 | -5% | 81.45 | 121.55 | 5% |
| 5 | -5% | 77.38 | 127.63 | 5% |
| 6 | -5% | 73.51 | 134.01 | 5% |
| 7 | -5% | 69.83 | 140.71 | 5% |
| 8 | -5% | 66.34 | 147.75 | 5% |
| 9 | -5% | 63.02 | 155.13 | 5% |
| 10 | -5% | 59.87 | 162.89 | 5% |
| 10-day cumulative change | -40.13 | 62.89 |
There are significant differences between holding an Inverse ETF and short selling.
Short selling requires a margin account.
The trader borrows these securities to sell at a higher price to other traders, and they can repurchase the asset at lower prices, thus winding up the trade by returning the lent securities.
However, there is a risk of costs rising after a short time in short selling, which exposes the investor to a virtually unlimited upside.
When an investor has an inverse ETF, and the underlying exposure is going down, the investor’s exposure in ETF is going up, i.e., the ETF NAV moves up, increasing the notional exposure to the position if the overall direction is correct.
Thus, this is precisely the opposite of what happens in short selling. Inverse ETFs allow the investors to short with a maximum loss of the value of the ETF, i.e., the NAV of the ETF.
Inverse ETF NAV moves up when the market is going down and converse if the market is falling.
Several types of inverse ETFs can be used to profit from declines in the market indices, such as Russell 2000 or Nasdaq 100. Some ETFs are also sector-specific such as energy, banking, FMCG, etc. Some investors use these inverse ETFs to hedge their portfolios against falls.
For instance, if an investor owns an ETF tracking the Nasdaq100, he could hedge his position with an inverse ETF that tracks the Nasdaq100.
However, such hedging can have its own set of risks since one of them is sure to make a loss in your portfolio. While this may appear appealing, losing money is also significant.
Inverse exchange-traded funds aren’t for everyone or even most investors. More experienced traders who understand what they’re investing in and why are better suited to use them.
Regular ETFs can still provide strong returns, and investors should stick to lower-risk products that can still generate attractive returns.
FAQs
Are inverse ETFs a good idea?
An inverse ETF is a high-risk investment option that may not suit risk-averse investors. This investment vehicle is suitable for highly risk-tolerant investors who are comfortable with the risk that inverse ETFs possess.
Who buys inverse ETFs?
Inverse ETFs are for highly risk-tolerant investors. Inverse exchange-traded funds aren’t for everyone or even most investors. More experienced traders who understand what they’re investing in and why they are investing in a particular asset are better suited to use them.
What is an example of an inverse ETF?
Several types of inverse ETFs can be used to profit from declines in the market indices, such as Russell 2000 or Nasdaq 100. Some ETFs are also sector-specific such as energy, banking, FMCG, etc. Some investors use these inverse ETFs to hedge their portfolios against falls.
For instance, if an investor owns an ETF tracking the Nasdaq100, they could hedge their position with an inverse ETF that tracks the Nasdaq100.
What does an inverse ETF do?
An inverse ETF (exchange-traded fund) is a type of ETF that rises when the underlying asset prices fall.
Inverse ETFs are similar to short-leveraged ETFs but differ in the gearing ratio. The gearing ratio is the means of measuring financial leverage to equity. Inverse ETFs generally have a gearing ratio of 1, whereas short-leveraged ETFs can have a gearing ratio of 2 or 3.
Short-leveraged ETF is ProShares UltraPro Short QQQ which provides a 3x daily short exposure on the Nasdaq 100.
Inverse ETF is ProShares Short Russell 2000 which provides a 1x daily short on the Russell 2000.
