How Investors Can Use It to Hedge Their Portfolio

by Project Compound
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Investing usually involves buying a security in the hopes that it will increase in value so you can sell it for a profit. But an inverse exchange-traded fund (ETF) takes a different approach. Rather than being profitable when the market performs well, these funds perform best when their underlying index (the group of assets the ETF owns) experiences a price decrease.

Are you interested in investing in an inverse ETF? Keep reading to learn more about inverse ETFs, the risks associated with them and how to invest in one.

The Short Version

  • Inverse ETFs are funds that profit when the underlying assets decline.
  • Investing in an inverse ETF allows an investor to profit from a declining benchmark without having to short a stock.
  • It’s a short-term investing strategy used by investors who want to time the market or hedge their positions.
  • There are a number of risks that investors should be aware of including compound risk, correlation risk, derivative securities risk and short-sale exposure risk.

What Is an Inverse ETF?

An inverse ETF is an investment vehicle that profits when its underlying assets lose value. It’s known as an inverse ETF because it delivers inverse returns. When the index performs well, the inverse ETF performs poorly. When the index performs poorly, the inverse ETF performs well.

An inverse ETF is similar to taking a short position on a stock. You’re essentially betting against the opposing ETF, and your investment is profitable when the opposing ETF loses value. Inverse ETFs are also known as short ETFs or bear ETFs.

How Does an Inverse ETF Work?

Like a traditional ETF, the value of an inverse ETF depends on an underlying group of securities (its “index”). The difference is that an inverse ETF uses derivatives like futures contracts to produce a performance that’s the opposite of the underlying index.

In some cases, an inverse ETF’s performance is the exact opposite of the underlying index. But there are also leveraged inverse ETFs. These see price movement several times that of the underlying index.

When it comes to investing, inverse ETFs work just like any other ETF. You buy and sell shares throughout the day like a stock. Inverse ETFs are intended to be short-term investments. They’re best suited for investors who are trying to time the market or hedge their positions and who don’t plan to take a buy-and-hold strategy.

Inverse ETF vs. Short Selling

Short selling is when you sell an asset under the assumption the price is about to decrease. Then once the price has gone down, you buy back the security at a lower price. You’ve made a profit by selling the asset for more than you paid for it. But you bought and sold in the opposite order of what we typically think of.

One important thing to note is that when you short a security, you often don’t own the asset you sell. Instead, you borrow securities, sell them, buy them back at a (hopefully) lower price and then return the securities to the original owner. And you keep the profit.

Inverse ETFs are similar to short selling in that both are taking a bearish position. In other words, you’re betting against a particular security, expecting its price to decline. Both strategies are profitable when the security loses value.

Differences Between Inverse ETFs and Short Selling

There are a few critical differences between the two. Short selling doesn’t describe a specific investment vehicle — it describes an investment strategy. An inverse ETF, on the other hand, is an actual investment vehicle that uses a similar strategy.

Another difference between the two is that, while both result in a loss if the asset’s price increases, the potential losses are very different. In the case of an inverse ETF, your losses are limited to the amount of your initial investment. If you invest $100 in the inverse ETF, you can’t lose more than $100.

But in the case of short selling, your losses are unlimited. Suppose you decide to short sell a particular stock. You borrow $100 worth of stock to sell, expecting its value to drop to around $70. If that happens, you have a profit of about $30.

But what if instead of losing value, the stock increases in value to $150? Instead of making a profit, you lose $50. If the stock price increases to $200, you lose $100. And if it increases to $250, you lose $150, which is more than you invested. And so on.

For an example of the potential losses associated with short selling, we need look no farther than the GameStock surge that happened in early 2021. After retail investors caught wind that hedge funds were shorting the stock, they began buying it in massive numbers. The hedge funds expected their strategy to be profitable, but it actually resulted in billions of dollars in losses.

Types of Inverse ETFs

There are two types of inverse ETFs:

  • Inverse ETF — A regular inverse ETF delivers the opposite performance of its underlying index. For example, suppose you invest in an S&P 500 inverse ETF. If the S&P 500 declines by 3%, your inverse ETF increases by 3%.
  • Leveraged Inverse ETF — A leveraged inverse ETF delivers multiple times the opposite performance of its underlying asset. Let’s say that instead of investing in a regular S&P 500 inverse ETF, you invest in a 2x S&P 500 inverse ETF. If the S&P 500 declines by 3%, your inverse ETF increases by 6% — double that of the underlying asset. Leveraged inverse ETFs have greater potential gains, but they also have greater potential losses.

What Are the Risks?

Every type of investing carries with it some level of risk, and it’s important to understand the risks unique to inverse ETFs before you get started.

Compounding Risk

One of the most significant risks associated with inverse ETFs occurs when you hold your position for more than one day. Just as investments can compound in your favor, inverse ETFs can compound to your detriment. Because the returns on an inverse ETF are percentage-based, the price resets each day. When the market is particularly volatile, your return could be less than you would normally expect. The compounding risk of inverse ETFs is one reason they’re best used as a short-term investment strategy.

Derivative Securities Risk

Inverse ETFs use derivatives to bet against the performance of a particular underlying index. As a result, they carry the same risks as any other type of derivative contract. For example, derivatives carry the credit risk that the other party can’t (or won’t) meet their obligation. They also come with liquidity risk, meaning investors may have a challenging time selling their holdings exactly when they want to.

Correlation Risk

Correlation risk occurs when the correlation (amount of price change) isn’t quite what you expected. In the case of inverse ETFs, correlation risk is partially due to the high fees and transaction costs often associated with these vehicles. In the end, your inverse ETF returns may not correlate as strongly to the performance of the underlying security as you expect. Like some of the other risks of inverse ETFs, the correlation risk becomes greater when you hold the investment for more than one day.

Short Sale Exposure Risk

When you invest in inverse ETFs, you end up with many of the same risks associated with short selling. For example, you’re vulnerable to volatility in the market and the fact that the underlying index could increase in value rather than decrease. You may also experience a lack of liquidity, forcing you to hold your position for longer than you had planned.

How and Why to Invest in Inverse ETFs

Wondering why someone would invest in inverse ETFs? Like other bearish strategies, inverse ETFs can be a way of hedging risk. While most ETFs and other funds profit when the price moves upward, the fact is that the market sometimes moves downward. And when it does, someone with inverse ETFs in their portfolio could be more insulated from the loss.

Inverse ETFs are also another way of timing the market and day trading. While they aren’t suitable as a long-term investment, someone who feels strongly that the market is about to experience a downturn could profit from them.

When it comes to how to invest in inverse ETFs, it’s actually quite easy. Like any traditional ETF, you buy and sell inverse ETF shares throughout the day in your brokerage account.

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The Bottom Line

Inverse ETFs are a unique investment vehicle where you make a profit when the ETF’s underlying index loses value. While inverse ETFs can be a good addition to a portfolio, they come with different — and sometimes greater — risks than other investments, and it’s important to understand what could go wrong. Before you dabble in inverse ETFs, make sure you have an exit strategy, since these securities aren’t generally suitable as a long-term investment strategy.

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