Investors use it in various advanced trading strategies, including taking a bearish stance in certain markets or hedging existing positions. And that is because they earn returns opposite of the underlying benchmark or index.
If you think you can take very short-term positions to improve your portfolio, then you should try the ETFs. So what is an inverse ETF fund, and how do inverse ETFs work?
Let’s, find out…
What Is an Inverse ETF?
It’s an ETF designed to use several derivatives to profit from a drop in the value of an underlying benchmark. Investing in the short ETFs is the same as holding several short positions. This involves borrowing some securities and selling them before buying them at an even lower price.
Most Bear ETFs use daily future contracts to earn returns. Usually, these contracts let you sell or purchase securities or assets at a set price and time. Futures let you bet on the trend of the security’s price.
But with inverse ETFs, you’ll be betting that the value will decline. Remember, when the market declines, the ETF will rise by a certain percentage minus the commissions and fees.
Bear ETF produces profits based on the daily change in the value of the index. Therefore, they’re ideal for short-term investment strategies; after all, volatility will erode the inverse ETFs returns with time.
Inverse ETFs Vs. Short Selling
Generally, short selling and Inverse ETF can produce the same results for investors. When short selling, you’re borrowing securities from the broker and selling them. And then, you can repurchase them when the price drops.
Therefore, you can profit when the value of the shorted security drops in the same way inverse ETF works. But there are several differences between the two that investors need to know about.
Firstly, purchasing Bear ETFs means your downside is usually limited to the total invested. In fact, the lowest it can reach is $0; therefore, you will have to worry about margin calls.
After all, the price of the shorted ETF can continue increasing indefinitely. Therefore, you’ll have to purchase the shares at some point.
The broker will call you and ask you to cover the short sale or add more cash to your account before everything get out of hand. This is margin calls.
On the other hand, short sales are made with margin loans. So they are not allowed in certain accounts, including the IRAs. The IRAs don’t allow margin loans; therefore, you can’t short-sell in the retirement account.
But inverse ETFs don’t allow margin loans, so you can use it instead of short selling.
When investing in short sales, you may have to pay a fee on top of the margin loan’s interest. Alternatively, you won’t pay a fee when purchasing inverse ETFs, but you’ll be charged a higher expense ratio.
Types of Inverse ETF
Generally, there are lots of ETFs that investors can use to profit from declines in certain market indexes like Nasdaq 100 and Russell 2000. Other inverse ETFs focus on certain sectors like consumer staples, energy, or financials.
Some of the inverse ETFs that benchmark the asset class include the U.S. Treasury and the S&P 500
While some investors love profiting from an inverse ETF when the market is declining. Others use it to hedge their portfolio against a losing price. For instance, traders with ETFs matching the S&P 500 can easily hedge a declining asset by purchasing inverse ETF for it.
If your S&P 500 is underperforming and drops by 2%, then if you had purchased an inverse ETF, it would have gained by 2%, covering your losses.
Unfortunately, hedging using inverse ETFs has its risks. For example, if the S&P rises, the investor would be forced to sell the inverse ETF. After all, they will be experiencing a loss when their original S&P starts gaining. Therefore, they should only be held for one day.
Remember, they are short-term financial instruments that have to be timed perfectly for you to make some money. Unfortunately, you can experience significant losses if you time your exits and entries poorly while investing too much cash in inverse ETFs.
One of the most widely traded indexes in the inverse leveraged ETF list is the ProShares UltraPro Short-QQQ. The SQQQ offers investors 3 times leverage daily downward exposure to the Nasdaq-100 index.
Before trading in these instruments, you must understand the inverse leveraged meaning. It’s an EFT that holds shareholder equity and debt. It uses your debt to multiply the ROI for investors.
Inverse ETF Example
ProShares Short S&P 500 guarantees inverse exposure to mid-size and large firms in the S&P 500. Generally, its net assets value is over $1.77 billion, while its expense ratio is 0.9%. Remember, ETFs are 1-day bets.
For example, the S&P experienced a decline in February 2020. But by February 17, its value started increasing. In fact, it rose from $23.19 on February 17 to $28.22 on March 23.
Therefore, if you had taken an inverse ETF before it started rising, then you would have made some profit. On the other hand, investors who held their positions for too long ended up making losses.
As aforementioned, investors use ETFs to hedge their positions, but did you know that you can also use leveraged ETFs? Generally, leveraged ETFs move 3 times the normal movement of your target asset. Therefore, you can magnify your ROI using short ETFs.
For instance, SQQQ uses futures and swaps to offer 3 times the daily performance on Nasdaq-100. Therefore, when Nasdaq drops by 2% on the first day, then the short-leveraged ETF will be 6%. But it will depend on the leverage used and how it relates to the news affecting the market.
If it drops by 1% on the second day, then the value of the ETF will be 9%, but if it gains 3% on the third day, then the index will still be low, thanks to significant volatility. This means that while the ETF gained 6% and 3%, it did lose by 9% on the 3rd day. It lost more value thanks to significant volatility.