What Are Inverse ETFs and How Do They Work?
Inverse ETFs, also known as bear ETFs or short ETFs, are pooled investment vehicles that allow investors to profit when a sector, index, or market declines. They are similar to traditional ETFs in that they allow for exposure to a wide variety of stocks with a single investment, but they are dissimilar in that they are structured to gain value when the securities that they track lose value. They accomplish this by using various derivative securities—like futures, options, swaps, and the like—to profit when the stocks and assets they track go down in price.
In other words, inverse ETFs are exchange-traded securities that provide investors with exposure to bearish positions in an array of related assets but without having to short anything themselves (which would require a margin account) or purchase individual derivatives.
Due to the derivative securities they use, inverse ETFs carry much more risk than traditional ETFs and typically charge higher fees.
Bear ETF Example: ProShares Short S&P500 (SH)
ProShares Short S&P 500 is an inverse ETF that aims to produce returns opposite the performance of the S&P 500 stock market index, which many investors and analysts look to as a benchmark for the American stock market at large.
On August 26th, 2022, for instance, the S&P 500 fell 3.37% by market close. The ProShares Short S&P 500 inverse ETF, on the other hand, rose by 3.37%.
What Are Short ETFs Used For?
Inverse ETFs are usually used for one of two purposes—hedging an existing long position to reduce risk, or making a bearish bet on a sector or index in the short term.
Hedging
Some investors use inverse ETFs to hedge existing long positions, especially during periods of volatility. For instance, if an investor is long on a variety of computer chip stocks (or a chip ETF), but the sector is experiencing volatility due to a supply issue, they could buy into an inverse tech ETF so that if their long positions lose value in the short term, they can recoup some of their losses by reselling their inverse tech ETF shares for a profit.
Bearish Speculation
Short ETFs can also be used to bet that a sector, index, or market will go down in price in the short term (e.g., one to several days). For instance, if an investor thinks the whole market will go down, perhaps due to a predicted hike in the Fed funds rate at an upcoming FOMC meeting, they could buy into the ProShares UltraPro Short S&P500, an inverse ETF that aims to inversely match the returns of the S7P 500 stock market index. If the market goes down by, say, 5% over the next few days, the investor’s inverse ETF shares would go up by roughly the same amount (minus any fees and commissions), and they could resell for a nearly 5% profit.
How Long Should Traders Hold Inverse ETFs For?
It’s important to note that, whether they are used for speculation or hedging, most bear ETFs are not held by investors for long. Bear fund managers tend to buy and sell futures contracts for the fund daily, so daily returns should be roughly equal and opposite to the returns of the underlying assets, but longer-term returns may vary, so holding an inverse ETF over the long term can be risky.
For this reason, inverse ETFs are better tools for traders than investors. They aren’t suitable for the buy-and-hold strategy, but they can be used to reduce risk or capitalize on short-term volatility.
What Sorts of Fees Are Associated With Inverse ETFs?
All ETFs charge a management fee known as an expense ratio, and expense ratios vary quite a bit depending on how complex a fund’s management is. Simple, fairly passive ETFs—like those that simply track major stock indexes—usually have fairly low expense ratios, usually in the range of 0.03–0.3%. Traditional ETFs with more specific goals and more active management strategies may have higher expense ratios in the 0.3–0.8% range.
Since inverse ETFs require very active management (fund managers usually buy and sell derivative contracts daily), they typically have higher expense ratios. According to a survey of 99 inverse ETFs by etf.com, the average expense ratio for bear funds in the U.S. is around 1.03%
What Is a Leveraged Inverse ETF?
Leveraged inverse ETFs use leverage (borrowed money) to amplify the fund’s returns (and losses). For instance, if a traditional ETF went down 3% in a day, a 3X leveraged inverse version of that ETF would go up by 9%. Similarly, if a traditional ETF went up by 4%, a 3X inverse leveraged version would go down by 12%.
Because they amplify returns and losses, leveraged ETFs are very risky and inherently more volatile than the traditional ETFs, sectors, or indexes that they track. Like other inverse ETFs, these are typically bought and sold over one or maybe several days—not held for the long term.
Leveraged Inverse ETF Example: ProShares UltraPro Short QQQ (SQQQ)
The ProShares UltraPro Short QQQ fund is essentially a leveraged version of the ProShares Short S&P500 fund mentioned above. Using leverage, this fund aims to inversely mirror the returns of the S&P 500 threefold.
On August 26, 2022, for instance, the S&P 500 went down 3.37% by market close, and the ProShares UltraPro Short QQQ fund went up 11.9%.
