What Are Inverse ETFs? Everything You Need to Know

Do you know what an inverse ETF is? Investors may try to profit from the Inverse market returns when share prices fall. This probably happens as a result of the erratic nature of the markets.

In short, it can be exciting to use an inverse exchange-traded fund today to try your hand at market timing.

Inverse ETFs first seem to produce returns polar opposite of an underlying index's investing performance. However, this is untrue because returns are more complex.

Investors should understand Inverse ETFs and how they operate before getting started.

How do inverse ETFs work?

A bear or short ETF sometimes called an inverse ETF, is an exchange-traded fund created to profit from a market downturn. 

Investors who predict that a particular market or security will lose value soon use these short-term, publicly-traded investments. In a downturn, they might use inverse ETFs to protect against losses.

John DeYonker, Head of Investor Relations at Titan, notes, "Inverse ETFs are a tool to hedge a stock portfolio." "If your benchmark, the S&P 500, increases by 1%, your hedge will decrease by 1%, and vice versa. 

Investors' volatility can be reduced by hedging with Inverse ETFs, like insurance. Thus, investors can also employ Inverse ETFs to profit from a foreseen drop. They could be utilized in place of short selling in this trend. 

For instance, an investor may decide to buy an inverse ETF of securities linked to energy producers if they think the oil industry will suffer a setback shortly. Their prediction may have been accurate if the investor's inverse ETF is profitable. 

Somehow, if the investor makes a mistake and the price of the market or a specific security rises, they may suffer a loss.

For instance, an investor who thinks the S&P 500 will fall may decide to buy shares of the ProShares Short S&P 500. The value of this inverse ETF is inversely proportional to the total value of the S&P 500 index.

Due to the daily compounding of their losses, inverse ETFs are frequently seen as investments with high volatility. Inverse ETFs are therefore riskier than the index to which they are linked.

How are inverse ETFs operated?

Inverse ETFs use derivative instruments to create a portfolio of assets that perform counter to a particular index or support. This includes options, forwards, swap agreements, and futures contracts.

An investor enters into a futures contract when they decide to buy or sell a specific asset at a specified price or even at a particular time in the future. 

Futures contracts serve as a stand-in for the investor, establishing an agreement to buy or sell particular investments when their value reaches a defined level. The automatic purchase or sale of assets at a later date can also be accomplished using these agreements.

Who should use Inverse ETFs?

Contrarian traders use inverse ETF funds to profit from the benchmark index's dropping value. These ETFs are high-risk investment vehicles, making them appropriate for experienced investors only. 

Inverse ETFs are not suitable for all investors, despite the assets' potential for high gains.

The losses might never end because short selling is a component of the inverse exchange-traded funds' business model. As a result, inverse ETFs are most advantageous to day traders and other short-term investors.

Additionally, investors with long-term investment horizons should not purchase these ETFs. They make suitable short-term investments because they deal in daily transactions. 

So you can invest in inverse exchange-traded funds if you have a short investment horizon, are familiar with market dynamics, and have a high-risk tolerance level.

Considerations to follow when investing in inverse ETFs funds

1. Financial horizon

Investors with a limited investing horizon should consider inverse exchange-traded funds. The returns may vary over time because they take day positions. As a result, investing in Inverse ETFs requires a short time horizon.

2. Investment purpose

Before investing in inverse exchange-traded funds, be aware of their investment objectives. An inverse ETF might follow a market index, theme, or sector. Choose the appropriate strategy based on how well these ETFs match your investment objectives.

3. Previous experience

Future returns are not guaranteed by past performance. Derivative trading is also dangerous. However, you can determine how successful the fund manager was at forecasting market movements by examining the ETF's historical performance.

4. Risk

Due to their speculative nature, inverse exchange-traded funds are high-risk investing options. These ETFs hold derivative positions every day. Derivative bets can occasionally work in your favor and result in significant losses. 

Consequently, these ETFs may lose all or most of their value. Therefore, before investing in inverse exchange-traded funds, it's crucial to consider the risks involved.

5. Spending ratio

Compared to conventional ETFs, inverse ETFs have a higher expense ratio. Inverse exchange-traded funds' expense ratio is more significant because they deal in financial derivatives. 

In addition, inverse exchange-traded funds are actively managed, requiring substantial technical knowledge and research. The fund management raises their fees as a result.

When should a trader invest in an inverse ETF?

Inverse ETFs can be best used in a variety of ways by traders. To protect themselves against other positions' prices decreasing, some traders, for instance, utilize short ETFs. 

As a result, the potential losses are capped as one position declines and the other rises. Other traders might place a directional wager on an asset or index using Inverse ETFs.

Leveraged ETFs, which aim to move two or three times the daily movement of the target asset, is another option for traders. Therefore, traders use leveraged short ETFs to boost investment returns. Leveraged ETFs can be compared to a fund on steroids.

For instance, the ProShares UltraPro Short QQQ ETF (SQQQ) offers three times the opposite daily performance of the Nasdaq 100 index through swaps and futures. So theoretically, this short ETF could increase by 3% if the Nasdaq 100 is down 1%. 

Everything depends on the leverage strategy employed and how it relates to the news that sparked the movement.

Even while it could sound alluring, there could be significant losses. Like other exotic market goods, financial derivatives have various responses to bad news. 

According to the underlying assets used, the leveraged short ETF in the fictitious example above could fall as much as 6 percent when the Nasdaq increases by 2 percent.

Consider your level of financial literacy and your involvement with your investments carefully. Even seasoned traders frequently begin modestly and have an exit plan. The two most important things are sticking to your schedule and knowing when to exit a losing position.

Regular ETFs can provide investors significant returns while avoiding some of the primary dangers of inverse ETFs, but they are not suitable for everyone.

Ranking of the best-performing Inverse ETFs for 2022

1. MicroSectors Gold Miners -3X Inverse Leveraged ETNs (GDXD)

One of the leading Inverse ETFs, GDXD, which provides inversely leveraged exposure to Global Gold Miners, gained over 32% last week. Rising bond yields and a strong U.S. dollar contributed to a slight decline in gold prices.

2. DUST - Shares of the Direxion Daily Gold Miners Index Bear

Another top inverse ETF with a return of around 21% last week was DUST, which offers inverse levered exposure to Global Gold Miners. Gold prices dropped due to higher interest rates and a strong dollar.

3. Shares of JDST - Direxion Daily Junior Gold Miners Index Bear

Another top-performing inverse ETF was Direxion Daily Junior Gold Miners Index Bear 2X Shares (JDST), which sought daily investment returns of 200 percent of the Inverse performance of the MVIS Global Junior Gold Miners Index. JDST returned more than 21 percent in the previous week.

4. SINV - ETFMG Prime 2X Daily Inverse Junior Silver Miners ETF

Last week saw a rise of about 17% for SINV, which tracks -2x the daily price changes of an index of small-cap silver mining and exploration businesses. Due to a strong USD and rising bond yields, silver prices decreased.

5. MicroSectors US Big Banks Index -3X Inverse Leveraged ETNs (BNKD)

On the list of top-performing inverse ETFs was BNKD, which tracks three times the inverse performance of an equal-weighted index of U.S. big banks. The financial sector declined by 2% last week, and the commercial banking component fell by 4%.

6. Silver ProShares UltraShort ETF (ZSL)

One of the top-performing Inverse ETFs last week as silver prices dropped in a rising rate environment was ProShares UltraShort Silver, ZSL, which gives -2x daily leverage to silver prices.

7. DRV - Shares of Direxion Daily Real Estate Bear

Last week, one of the best-performing inverse ETFs was the DRV ETF, which provides -3x daily leverage to an index made up of U.S. REITs. As higher rates are anticipated to harm the housing market, the entire real estate sector declined by 0.02 percent.

8. FAZ - Shares of Direxion Daily Financial Bear

The financial sector was the worst-performing sector last week, dropping 1.9 percent. FAZ, which offers 3x daily short leverage on the Russell 1000 Financial Services Index, also topped the list. Concerns over the economy's growth in the face of rate hikes caused the financial industry to decline.

9. Direxion Daily S&P Oil and Gas Exp. & Prod. Bear 2X Shares

Along with another top-performing inverse/leveraged ETFs, Direxion Daily S&P Oil & Gas Exp. & Prod. Bear 2X Shares saw an increase of about 8% over the previous week.

10. Direxion Daily Technology Bear 3X Shares (TECS)

Another inverse technology ETF, TECS, topped the list last week after increasing by more than 8%. As a result of investors avoiding growth and technology stocks at the moment, the technology sector declined. 

Technology equities are vulnerable to rising interest rates and are predicted to decrease in a rate environment with rising rates.

Short selling vs. inverse ETFs: what's the main difference?

Inverse ETFs do not require the investor to maintain a margin account, which would be necessary if they wanted to open short positions. 

In a margin account, a broker loans money to a trader so they can make a profit. Shorting is a sophisticated trading strategy that uses margin.

Investors that take on short positions do so to sell the securities to other traders; they do not own the stocks. The objective is to sell the asset back at a loss and close the trade by giving the margin lender the shares. 

The possibility exists that the security's value will increase instead of decline, forcing the investor to repurchase the shares at a price higher than the margined sale price.

A stock loan charge must be paid to a broker for borrowing the shares required for a short sale and a margin account. High short interest in-stock may make it difficult to find shares too short, which raises the cost of short selling. 

The cost of borrowing shares too short can frequently be higher than 3% of the borrowed amount. You can understand how inexperienced traders may easily surpass their capabilities.

On the other hand, inverse ETFs frequently have expense ratios around 2 percent and are open to everyone with a brokerage account. Despite the expense ratios, investing in an inverse ETF is still more straightforward and less expensive for a trader than shorting equities.

Primary reasons for investing in Inverse ETFs funds 

The significant reasons for investing in inverse ETF funds are as follows:

1. Higher returns

When the market behaves as expected, these ETFs have the potential to produce significant returns. Inverse exchange-traded funds profit when the value of the benchmark index declines, to put it another way.

2. An alternative to financial derivatives

Inverse ETFs indirectly offer access to financial derivatives like options and futures contracts. Dealing with derivatives is challenging and not for everyone. The transactions may be pricey as well as difficult to access. Investors can benefit from trading derivatives by using these ETFs.

3. Hedging

Investors can diversify within an asset class using these ETFs while protecting themselves from losses. You could invest in an inverse exchange-traded fund, for instance, if you have an ETF that tracks the NIFTY 50 benchmark. 

You can make up your losses if the value of the NIFTY 50 drops.

What are the benefits of Inverse ETFs?

A few essential benefits of Inverse ETFs are:

1. If investors are concerned that markets may fall but do not want to sell their equities, they can try to hedge their long positions with Inverse ETFs.

   
   

2. Inverse ETFs provide indirect access to financial derivatives, such as futures contracts, that could otherwise be difficult for regular investors to trade or unavailable.

   
   

3. Shares of inverse ETFs trades are simple to access on the open market like stocks, just as standard ETFs. In retirement accounts, which frequently do not allow derivatives or short selling, investors may also employ Inverse ETFs.

What are the drawbacks of Inverse ETFs?

1. Compared to standard ETFs, inverse ETFs have higher fees because of active daily management and additional costs related to financial derivatives.

   
   

2. Because inverse ETFs aim to outperform their daily benchmark, long-term performance won't always produce returns that are equal in size.

   
   

3. Even daily, inverse ETF strategies may not produce exact inverse movements.

Investment tips to follow 

1. Speak with a financial counselor if you're unsure if an inverse ETF is good for you. Finding the ideal financial advisor who meets your demands is not challenging. The free application from SmartAsset matches you with local economic experts in five minutes. 

   
   

2. While ETFs and mutual funds can be comparable, there are also essential differences for investors to be aware of. If you are investing on an extremely tight budget, you might want to do your research or speak with a financial expert.

   
   

3. If investors understand what they're getting into, an ETF might be a welcome addition to a 401(k). Before leaping, check the costs and do the math.

Related questions - FAQs

1. Are inverse ETFs a wise investment?

Investors should be fully aware of the specific risks associated with Inverse ETFs before investing in them because of how they are designed. Compounding risk, derivative securities risk, correlation risk, and short sale exposure risk are the main hazards of investing in Inverse ETFs.

2. Can you lose everything in an inverse ETF?

If you invest in an inverse ETF and the market for your fund increases, you will experience a loss. If the fund is leveraged, you risk suffering significant losses. Bear markets and market turbulence are different from rising markets.

3. Is zero possible in an inverse ETF?

Long-term, highly leveraged inverse ETFs, or funds that produce three times the opposite returns, tend to converge to zero (Carver 2009). This also holds for short ETFs with smaller leverage when the underlying index is highly volatile.

4. How long is an inverse ETF allowed to be held?

Inverse ETFs are designed to be traded during the day. If you carry a position in an inverse ETF for more than a single day, you should at the very least keep track of your holdings daily.

Bottom line

Investors typically utilize Inverse ETFs as a strategy to speculate against changes in the markets. Some savvy investors use them as a hedge against the value decline of a particular asset class or index, benefitting from falling prices. Nevertheless, holding shares directly may be less risky than using Inverse ETFs.

They are typically not intended to be long-term investments. Additionally, as many use leverage, their gains or losses concerning the assets or index they seek may be increased.