Inverse ETFs trade like traditional stocks but generate returns inversely proportional to a given index, allowing investors to hedge or speculate in a bear market without requiring a margin account. They can also be used for investment strategies, such as segregating risks from different parts of the market. Inverse ETFs use derivatives, creating leverage and amplifying potential gains and losses. Compared to mutual funds, ETFs have relatively low annual fees but investors must pay a commission to the brokerage for buying and selling ETF shares.
A reverse exchange-traded fund (inverse ETF) is a fund that trades like a traditional stock on an exchange, but produces a return that is inversely proportional to a given index. For example, the Short Standard & Poor’s 500 (S&P 500), which is the inverse ETF of the S&P 500, will generate approximately a 12 percent return when the S&P 500 falls 12 percent. Similar to a short position in an individual stock, an inverse ETF allows an investor to hedge or speculate in a bear market. Unlike taking a short position, however, the inverse ETF, also called a short ETF, does not require a margin account, allows a short position on an entire index, and limits the scope of an investor’s potential loss to the amount of the original investment.
In addition to speculative gains, investors can use inverse ETFs for a variety of investment strategies. When combined with other assets, inverse ETFs can allow an investor to segregate risks from different parts of the market. For example, an investor may choose to hedge a bear market by investing in the S&P 500 Reverse ETF, while at the same time investing in a long Commodity ETF. Many investors will alternate between inverse ETFs and long ETFs based on market volatility. When the Chicago Board Options Exchange (CBOE) Volatility Index is above 30, investors will invest in short ETFs and, conversely, when the CBOE Volatility Index falls below 30, they will hold long positions.
A unique feature of inverse ETFs is the use of derivatives. Derivatives are securities based on contracts between two or more parties, the value of which is derived from the value of one or more underlying assets, such as stocks, commodities, interest rates, or currencies. Derivatives are traded with borrowed money, creating leverage and amplifying potential gains and losses. Dramatic price fluctuations can lead to an indefinite correlation of the ETF’s share price with the benchmark.
Compared to mutual funds, ETFs have relatively low annual fees. One reason for the low fee is the fact that ETFs are passively managed, with changes tied to changes in the index. Market timing is critical, and investors must be aware of the decision of when to exit and enter certain markets. Investors must pay a commission to the brokerage for buying and selling ETF shares. Commissions for trading ETF shares can add substantially to the cost of investing.
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