What Is An Inverse ETF, and How Do They Work?

Inverse ETFs allow investors to profit from market downturns, but how do these investment vehicles work, and should investors avoid them?

by | Last updated 1 Mar, 2023 | Investment Funds

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An inverse ETF is a special type of exchange-traded fund that enables investors to profit from a downturn in the stock market.

The most common type of ETF is an index tracker. As the value of a market index increases, shareholders within the fund generate a profit. An inverse ETF is the opposite and is sometimes referred to as a short ETF or bear ETF.

When the value of an index decreases, shareholders make a positive return. However, these funds aren’t limited to simply indices. They can track the inverse performance of nearly any asset class, including stocks, bonds, real estate, currencies, and commodities.

Some investors use this type of investment vehicle as a means to generate a positive return during bear markets. However, professional traders also use inverse ETFs as a hedging mechanism against risk.

How do they work?

An inverse exchange-traded fund uses financial derivatives to deliver the opposite return of the asset class it is tracking. Daily futures contracts, options, swap agreements, and forward contracts are usually used to achieve this.

Being able to trade financial derivatives requires a brokerage account granting access to this section of the market. However, these types of investment accounts are usually reserved exclusively for professionals due to the high-risk nature of these instruments. By investing through an inverse ETF, investors can indirectly profit from these derivates without purchasing derivatives directly, bypassing this limitation entirely.

Over long periods of time, the overall stock market appreciates in value. And while these gains compound over time with a regular ETF, in an inverse ETF, the losses compound instead. As such, holding a position in an inverse exchange-traded fund for the long term will almost certainly destroy wealth.

These are designed to be short-term instruments that investors and traders can use to speculate on sudden events.

For example, if an investor believes the UK stock market will decline due to a recession in 2023, they may purchase an inverse ETF of the FTSE 100. If the investor is correct, and the index drops in value, the percentage decline becomes their profit. But if the investor is wrong and the index increases in value, then the investor suffers a loss.

What are leveraged inverse ETFs?

For speculators, using leverage is a strategy that can significantly amplify investment profits. An inverse leveraged ETF uses borrowed capital to purchase additional futures contracts and other derivatives within its portfolio, promising to return the borrowed money at a later date with a bit of interest.

The result is that investors can use more capital than they currently have to invest. And if an investment is successful, the returns are greater proportional to the amount of money borrowed.

For example, let’s say an investor were to buy shares in an inverse FTSE 250 ETF that uses 3x leverage. Every time the underlying index, in this case, the FTSE 250, declines by 1%, the investor would profit by 3%.

However, leverage works both ways. Let’s say the FTSE 250 rises by 2% instead. In that case, the investor has now suffered a 6% loss.

Sudden upward volatility can quickly make an investment in a leveraged ETF plummet. That’s why these investment vehicles are considered extremely risky and only suitable for experienced investors or traders.

Is an inverse ETF the same as short selling?

Another popular method of profiting from stock market declines is short-selling. This is a trading strategy where an investor borrows a number of shares from a broker and instantly sells them.

However, to access this money, the investor first needs to return the borrowed shares by repurchasing the exact amount and paying for the dividends that may have been received while they borrowed the shares.

The objective is to repurchase the shares once the stock price has fallen. Then the difference between the initial selling price and the future buying price becomes the investor’s return.

Of course, if the share price were to increase instead of decrease, the investor is obliged to repurchase the shares even at the higher price. And consequently, incurs a loss that can be greater than the amount of money invested in the first place.

Short selling and investing in an inverse ETF ultimately have the same investment objective – to profit from a decline in asset prices. However, a key difference is that investing in an inverse ETF does not require a margin account. And, therefore, is easier to access.

What are the advantages of an inverse ETF?

As previously stated, an inverse ETF is a high-risk, high-reward investment vehicle designed for sophisticated investors. However, there are some notable advantages to taking on this high level of risk.

  • Amplified Earnings – Investors can quickly earn multifold returns, especially if using leverage.
  • Profit from Market Downturns – If markets are in freefall, investors can capitalise on the situation and generate a positive return.
  • Hedge Against Risk – Used correctly, inverse ETFs can be used as an insurance policy on risky trades, hedging against downside risk.
  • Diversity of Choice – The US and UK stock market houses a wide range of inverse ETFs for investors and traders to choose from. As such, it’s typically easy to find a fund suitable for a given investment objective.

What are the disadvantages of an inverse ETF?

While prudently investing in an inverse ETF can deliver explosive returns, it can easily backfire, introducing immense volatility.

  • Compounding Losses – Most inverse ETFs track the daily return of an underlying asset class or stock index. If the underlying asset’s price appreciates for multiple days in a row, it can compound investor losses.
  • Derivative Risk – Inverse ETFs using financial derivatives can introduce extreme volatility risk, credit risk, and liquidity risk that can harm investor returns.
  • Correlation Risk – Inverse ETFs seek to provide a high level of negative correlation to an investment portfolio. However, the regular daily rebalancing of an inverse portfolio can rack up additional costs, such as trading fees.
  • Higher Taxes – Used correctly, an inverse ETF can generate a large investment return in a short space of time. However, as a consequence, these gains can be taxed at a higher rate depending on which country the investor resides in.
  • Higher Management Fees – An inverse ETF is an actively managed investment fund. As such, the annual management fee and, in turn, the expense ratio is likely to be higher than a traditional ETF, harming the total return on investment.

The bottom line

Investors use inverse ETFs to speculate and benefit from the opposite market movements. These are complicated financial instruments and hence best suited for sophisticated investors.

These ETFs are a great short-term investment. In fact, the dynamics of these financial instruments also indicate that it is not ideal to hold them for a longer period unless investors have the assurance of a highly bearish view of the market.

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This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.

Written By

Saima Naveed

Saima spent the early days of her career advancing the finance office of a prominent manufacturing business. After taking a sabbatical, she decided to use her expert knowledge and apply it to the stock market. Now, 10 years later, she manages a substantial portfolio built using detailed and thorough analysis.

Outside The Money Cog, Saima is an avid supporter of empowering women in the workplace. She is currently working very closely with Women of Wonders Pakistan to help other women achieve their career goals.

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Edited & Fact Checked By
Zaven Boyrazian MSc

Zaven has worked in several industries throughout his career, from aircraft factories to game development studios. He has been actively investing in the stock market for the better part of a decade, managing over $1 million across multiple portfolios.

Specializing in corporate valuation, Zaven employs a modern take on the principles set out by Benjamin Graham to find new opportunities at fair prices.

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