Inverse Financial ETFs: Definition, Risks, and Strategies

Inverse financial ETFs are a type of investment product that allows you to profit from a market decline. They do the opposite of traditional ETFs, which aim to track the performance of a specific market index.

These ETFs are designed to increase in value when the underlying market declines, and decrease in value when the market rises. Inverse financial ETFs are often used by investors who want to hedge their portfolios against potential market downturns.

One key thing to keep in mind is that inverse financial ETFs can be highly volatile, and their performance can be unpredictable. This is because their value is tied to the performance of the underlying market, which can be affected by a wide range of factors.

Inverse ETFs are exchange-traded funds that use financial derivatives to provide daily returns opposite to the returns of the index or security they track.

They achieve this by holding swaps with banks, which act as the counterparty in a futures contract on the underlying security.

The ProShares Short S&P 500 ETF, for example, holds such swaps with various banks.

The fund's value will decrease when the S&P 500 index goes up, because it must pay the daily return to the counterparties from its cash holdings.

Holding an inverse ETF for more than a day can produce returns that don't track with the total return of the underlying security.

This is especially true for volatile underlying securities, which can result in greater tracking error.

Inverse ETFs produce their returns based on the daily change in the underlying security's value.

Inverse ETFs use various derivatives like futures, swaps, and options contracts to take short positions in the underlying index. They rebalance daily to maintain the inverse relationship as markets move each trading day.

A futures contract is a contract to buy or sell an asset or security at a set time and price. Futures allow investors to bet on the direction of a securities price.

Inverse ETFs' use of derivatives—like futures contracts—allows investors to make a bet that the market will decline. If the market falls, the inverse ETF rises by roughly the same percentage minus fees and commissions from the broker.

Here are some key facts about how inverse ETFs work:

Inverse ETFs use derivatives like futures, swaps, and options contracts to take short positions in the underlying index, rebalancing daily to maintain the inverse relationship as markets move each trading day.

These derivatives, such as futures contracts, allow investors to bet on the direction of a security's price. A futures contract is a contract to buy or sell an asset or security at a set time and price.

Inverse ETFs are not long-term investments since the derivative contracts are bought and sold daily by the fund's manager. This means there's no guarantee that the inverse ETF will match the long-term performance of the index or stocks it's tracking.

The use of derivatives allows investors to make a bet that the market will decline, and if it does, the inverse ETF rises by roughly the same percentage minus fees and commissions from the broker.

Here are some key characteristics of inverse ETFs:

However, inverse ETFs can also lead to losses quickly if investors bet wrong on the market's direction, and holding them for more than one day can lead to losses as well. Higher fees exist with inverse ETFs versus traditional ETFs.

Short selling is a complex and often misunderstood concept. It involves borrowing shares of a stock or other security from your broker and selling them with the goal of buying back the shares at a lower price later.

To short sell, you typically need a margin account, which is a type of account that allows you to borrow money from your broker to trade. This can be a challenge for investors who don't have a margin account or who are looking to short sell in a retirement account.

Short selling can be costly, with stock loan fees paid to the broker for borrowing the shares ranging from 3% to 5% or more of the borrowed amount. This can be a significant expense, especially for inexperienced traders.

The downside of short selling is that there is no limit to how high the price of the shorted asset can go. In contrast, inverse ETFs have a limited downside, with the lowest price they can trade for being $0.

Here are some key differences between short selling and inverse ETFs:

Overall, short selling can be a high-risk, high-reward strategy that requires a significant amount of knowledge and experience. Inverse ETFs, on the other hand, offer a more accessible and cost-effective way to take a bearish position in the market.

Investing in inverse ETFs can be a tricky business, and one of the biggest disadvantages is the potential for volatility loss. This means that even if you're directionally accurate about a security declining in value, you can still lose money with an inverse ETF.

Volatility loss occurs when the underlying security bounces back and forth in value, causing the inverse ETF to lose more value than the security itself. In the example given, an underlying security declined by 10% one day, but then recovered 25% the next day, resulting in a net loss of over 4%.

The key takeaway is that inverse ETFs can be a bad choice in volatile markets, where prices are constantly fluctuating. This is because their mechanisms for providing inverse returns are only effective for short periods or steady declines.

If you had shorted the index by selling an ETF, you would have generated a profit over the same three-day period. This highlights the importance of considering alternative strategies, such as short selling, when investing in inverse ETFs.

Traders may use inverse ETFs to profit from or hedge against declines in a specific market. Short-term traders may also use them to speculate on downward moves.

Inverse ETFs can be a useful tool for traders who want to bet against a particular market. According to the Financial Industry Regulatory Authority, inverse ETFs allow traders to profit from a decline in a specific market.

Here are some key strategies and motivations for using inverse ETFs:

Traders may use inverse ETFs to protect their portfolios from losses or to take advantage of a potential market downturn.

Traders may use inverse ETFs to profit from or hedge against declines in a specific market.

Inverse ETFs can be a useful tool for short-term traders who want to speculate on downward moves.

Traders may also use inverse ETFs to hedge against potential losses in their portfolio.

According to the Financial Industry Regulatory Authority, inverse ETFs can be used to profit from market declines.

Here are some reasons why traders may use inverse ETFs:

Inverse ETFs work best in the short term, so it's essential to use them as a short-term hedge or directional bet on the market.

They're best used when you have a specific market event or earnings report that you're anticipating, such as the Fed announcing an unexpected monetary policy or tech stocks reporting earnings.

In these situations, you can buy an inverse ETF around the event to hedge your investments and put a cap on the downside and upside of unexpected results.

For example, you might buy the Direxion Daily Technology Bear 3x Shares before tech stocks report earnings and sell after the report to hedge your investments.

Keep in mind that using inverse ETFs in your portfolio is an advanced strategy, and it's crucial to know when to enter and exit a position in an inverse ETF because they can move against you very quickly.

Even if you're directionally right, volatility loss can destroy your profits, so keep the holding period to a minimum, ideally just until the event or earnings report is over.

Leveraged ETPs attempt to provide a positive multiple of an index's performance over a specified time, usually just one day. They can offer returns equivalent to 1.5x, 2x, or even 3x the performance of an index during a single day.

These funds employ complex strategies involving derivatives, primarily futures and swap contracts. They're designed to be held for only a single day, not longer periods.

Investors who leave their money in a leveraged ETP over a longer period may be surprised to discover their returns are nowhere near the return on the underlying index. In fact, they might even suffer a loss from an investment tracking an index that has risen.

A 2x leveraged ETP, for example, would aim for a 4% return if the index rose 2%. However, if the index fell, the loss would also be magnified by 2x.

Leveraged ETPs are inherently volatile and amplify a portfolio's risk profile. They're probably not suitable for most investors, but for those who think they can handle the risk, it's essential to read the prospectus and fully understand the product's investment objectives, investment strategies, risks, and costs.

Here are some key differences between leveraged and inverse ETPs:

Investors should be aware that even if they're directionally right, volatility loss can destroy their profits. To minimize losses, it's essential to keep the holding period to a minimum.

Inverse ETFs are most useful as a very short-term hedge due to the high expense ratios and the mechanisms used for providing inverse returns.

Most investors won't be able to use them as part of a solid investment strategy.

Buying an ETF that tracks a broad-based market index and charges a very low expense ratio can produce great results with minimal effort.

It's generally a better idea to stick with a simple strategy like this rather than trying to use inverse ETFs in your portfolio.

Inverse and leveraged inverse ETFs tend to have higher expense ratios than standard index ETFs.

These higher costs can eat away at performance, making it essential to carefully consider the fees associated with an inverse ETF.

The costs can be significant, so it's crucial to factor them into your investment decisions.

Fees can eat away at your investment returns, making it harder to reach your financial goals. Inverse and leveraged inverse ETFs tend to have higher expense ratios than standard index ETFs, which can be a significant drag on performance.

Higher fees mean less money in your pocket, so it's essential to understand the costs associated with your investments. These costs can add up over time, making a big difference in your long-term returns.

Standard index ETFs typically have lower fees, often in the range of 0.05% to 0.20% per year. This is because they are designed to track a specific market index, which requires less management and oversight.

Even small differences in fees can make a big impact on your investments over time. For example, a 1% difference in fees can result in a 10% difference in returns over a 10-year period.

The average annual return for a balanced mutual fund is around 7-8%, according to historical data. This means that if you invest $10,000, you can expect to earn around $700 to $800 per year.

Investors with a higher risk tolerance may be able to earn higher returns, but they also face a greater risk of losses. A study of 10,000 stocks over a 20-year period found that the top 10% of performers averaged a return of 18.6% per year.

In contrast, a conservative investor who chooses a low-risk investment may earn an average return of around 4-5% per year. This is still a respectable return, especially considering the lower risk involved.

A 10-year analysis of a popular index fund found that it consistently beat the market average, with an annual return of 9.2%. This is a great option for investors who want to minimize risk while still earning a decent return.

If you're looking to diversify your portfolio with bear funds, there are many options available.

Several well-known fund providers offer bear funds, including AdvisorShares, BetaShares, Direxion, ProShares, and HBP.

The funds from these providers can be traded on various exchanges, such as the NYSE Arca, ASX, and LSE.

For example, AdvisorShares offers the Ranger Equity Bear fund, which trades on the NYSE Arca under the ticker HDGE.

BetaShares has a range of bear funds, including the Australian Equities Bear Hedge Fund, which trades on the ASX under the ticker BEAR.

Direxion and ProShares also offer a range of bear funds, including the Financial Bear 3X and the Short Dow 30 fund, which trade on the NYSE Arca under the tickers FAZ and DOG, respectively.

HBP offers a large number of bear funds, including the S&P/TSX 60 Bear Plus ETF, which trades on the TSX under the ticker HXD.

Here is a list of some of the bear funds mentioned in this section:

Closings and splits can be a confusing and unsettling experience for investors, especially if they're not aware of the possible outcomes.

Some leveraged and inverse ETPs may avoid delisting by using a reverse share split, which exchanges multiple lower-priced shares for a new, single share with a higher price.

This technique allows issuers to maintain the total value of the investment, but investors will see a higher share price in their accounts with a corresponding decline in the number of shares they own.

Investors should be aware that a reverse share split does not necessarily mean the fund is performing well, it's just a way to keep the fund alive.