What Are Inverse ETFs?

The design of inverse ETFs is to return the exact opposite performance of a specific index.

Inverse ETFs are a type of Exchange-Traded Funds that are made by using certain derivatives. The ultimate motive is to profit from declines in the value of underlying benchmarks.

The design of inverse ETFs is to return the exact opposite performance of a specific index. Such an investment is likened to holding a short position, hence, in some circles, they are referred to as bear ETFs or short ETFs. They allow a short exposure to a particular index.

Are Inverse ETFs Preferred? 

Inverse ETFs became a preference for traders who were initially shorting stocks in order to seek bearish positions. They preferred this since shorting individual stocks posed various risks on many levels. It also proved costly at times to short stocks as a trader would inevitably have to borrow on margin or end up paying high fees for the borrowed money.

Another reason why inverse ETFs have become a preference to many traders especially those who do put options is because initially, they had to trade the options in a limited time frame. They were under so much pressure to beat the expiry time. However, with Exchange Traded Funds, there is no such pressure. A trader can actually hold the inverse ETF for an extended time period hence posing as a better option than put options.

Most investors who go the inverse ETF route do not have a long-term horizon with regard to the investments. Even so, these ETFs make use of daily futures contracts in order to have great returns.

Advantages of Inverse ETFs

ETFs do not require investors to hold margin accounts. This provides a great convenience especially for investors who want to enter short positions. Investors can choose those ETFs that profit from the declines in the broad market indexes. An example of such a broad market index is the NASDAQ 100 and the Russell 2000.

Another advantage that inverse ETFs have is the fact that some focus on a specific sector. Hence, as an investor, you can choose a specific sector of choice out of the following:

  • Consumer products
  • Energy sector
  • Financial sector
  • Agricultural sector

Another upside of inverse ETFs is that they can be used as a hedge to portfolios against the impact of falling prices.

The expense ratios of inverse ETFs are less than 2% which is quite favorable and can be purchased by anyone that has a brokerage account.

While many ETFs are designed to gain from the declines of certain sectors or markets, there are many others that give a form of leverage. They are referred to as leverage ETFs. Classic examples include Direxion and other big time providers such as ProShares. They are employed in a similar way as derivative based ETFs and are often used by momentum traders and speculators. These speculators normally hold on to these positions for quite a short time usually just a few days. The leveraged ETFs, as well as the inverse ETFs, can be used as daily tools owing to the re-jiggering that’s necessary to make products function.

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An important thing to note with inverse ETFs is that the daily performance is the premise of all trades. The re-balancing of investments and strategies is done on a daily basis for the purpose of maintaining a constant leverage ratio.

The Downsides of Inverse ETFs

The first downside can be derived from the high expense ratios. This is due to the fact that Inverse ETFs are actively managed funds. But, if you hold inverse ETFs for a short while, you are better off.

Secondly, inverse ETFs are likely to underperform in the long run. You are better off shorting stocks or index funds.

Is It Advisable To Use Index Funds?

If you’re seeking a short-term market timing or hedging, then it’s advisable to use inverse ETFs. However, due to their daily re-balancing needs, they are best handled by professionals and investors who have the requisite experience.

If you’re thinking of going the inverse ETF way, then you can tap on to the Proshares Short S&P500. It’s currently the largest inverse ETF in the market.

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In conclusion, inverse ETFs are the best picks for risk-tolerant traders owing to the advantage it brings in establishing short positions.