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Understanding Inverse ETFs

  • Akshit Anthony
  • Nov 11, 2021
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Do you secretly despise financial journalists who deliver pessimistic market forecasts each morning when you read your newspaper? Are you concerned about your financial security as a result of the incessant whispers of the end?


In either scenario, by investing in the appropriate fund-inverse exchange-traded funds, you may profit from these news articles about doomsday-like occurrences. You may increase your odds of success by purchasing an inverse ETF when the rest of the world is betting on rising markets.



What is an Inverse Exchange-Traded Fund (ETF)?


An inverse exchange-traded fund (ETF) is designed utilising multiple derivatives to profit from the drop in the value of an underlying benchmark. Investing in inverse ETFs is comparable to holding several short positions, which entail borrowing and selling securities to repurchase them at a reduced price. 


Inverse ETFs are frequently referred to as "Short ETFs" or "Bear ETFs." ETF Dividends and Bitcoin Future ETFs are gaining popularity these days. 


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Essential Takeaways


  • An inverse exchange-traded fund (ETF) is designed utilising multiple derivatives to profit from the drop in the value of an underlying benchmark.

  • Investors can profit from market or underlying index decreases without having to sell anything short.

  • Fees are often higher for inverse ETFs than for standard ETFs.


Let us learn more about inverse ETFs


Watch this video to understand about inverse ETFs. 


Discovering Inverse ETFs


Here's a deeper look at how inverse exchange-traded funds function.


Due to the inherent risk associated with inverse ETFs, it is prudent to do due research. There are inverse exchange-traded funds (ETFs) connected with various current indexes. ETF providers such as ProShares and Direxion offer a selection.


While there are exhaustive lists of some of the greatest ETFs available, various factors should affect your choice. Your risk tolerance, current assets, and familiarity with current market patterns all play a significant role.


While you can monitor the performance of the inverse ETF you're contemplating, it's always a good idea to consult your broker. Consider leaving inverse ETF investing to the specialists since it can be a dangerous move for amateurs due to these funds' daily rebalancing.



Understanding Inverse ETFs


Inverse exchange-traded funds (ETFs) rely on derivatives to generate profits for their investors. Inverse exchange-traded funds invest in daily futures. Additionally, a futures contract is referred to as a futures agreement. It enables two parties to agree to buy or sell a security or asset later at an agreed price. 


A trader or fund manager purchases a futures contract to wager on the market decline. If the index falls by 22%, the inverse ETF increases by 2%. An inverse ETF might be a short-term investment because it is based on daily-traded derivatives such as futures contracts.


Numerous inverse ETFs get their earnings from daily futures contracts. A futures contract is an agreement allowing the purchase or sale of an asset or security at a specific price and date. Futures allow investors to wager on the direction of the cost of security.


Through derivatives such as futures contracts, inverse ETFs enable investors to wager on the market decline. If the market declines, the inverse ETF increases by nearly the same proportion, with fewer brokerage costs and charges.


Inverse ETFs are not long-term investments, as the fund's manager purchases and sells derivative contracts daily. Therefore it's clear that there is no way to ensure that the inverse ETF will track the index or equities it is tracking over the long run. Frequent trading frequently results in a rise in fund fees, and some inverse ETFs have expense ratios of 1% or more.



Leveraged inverse exchange-traded funds (ETFs)


Are you persuaded that the benchmark index's drop will continue? Your confidence, understanding, and risk tolerance all correlate with the performance of your inverse ETF. Borrowing, in addition to derivatives, can be used to enhance the index. Leveraged inverse ETFs may boost returns by a factor of two or three. It means that if the NIFTY50 falls by 3%, your leveraged inverse ETF 3x will climb by 9%.



Advantages and Disadvantages of Inverse ETFs


An inverse ETF enables investors to effectively "short" a stock without incurring many associated risks. Shorting involves investors acquiring and selling shares through a margin account with their broker. If the security price exceeds the margin price agreed upon, the investor is responsible for the difference. Additionally, shorting entails a stock lending charge of up to 3%.


Typically, inverse ETFs have cost ratios less than 2% and are available to anybody with a brokerage account. Although this is a larger ratio than regular ETFs, it is still less expensive than shorting.


Additionally, inverse ETFs are used to hedge against a portfolio's more favourable holdings. If an overall portfolio has numerous ETFs that track an existing index, an inverse ETF tracking the same index may provide further protection in the event of a market decline. If the underlying market increases, investors can sell inverse ETFs to protect themselves from losses.


Due to their speculative character, inverse ETFs can still be risky investments. If an investor wagers on a market or index decline and increases, the investor may incur a loss. Suppose a leveraged inverse ETF guarantees two-to-one gains. In that case, it may also provide two-to-one losses in the event of a market rally.


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This image describes risks associated with ETF investing

Types of Risk in Inverse ETFs

Types of Risks Involved in Investing in Inverse ETFs


Inverse exchange-traded funds (ETFs) strive to provide returns that are the inverse of their underlying indexes. Inverse ETFs often employ derivative assets, such as swap agreements, forwards, futures contracts, and options to fulfil their investment objectives. Inverse exchange-traded funds (ETFs) are created for speculative traders and investors to execute tactical day trades against their underlying indices.


For a single day, inverse ETFs seek investment returns that are the inverse of their benchmarks' performance. Consider an inverse ETF that tries to replicate the inverse performance of the Standard & Poor's 500 Index. Thus, if the S&P 500 Index climbs by 1%, the ETF should theoretically decline by 1%, and vice versa.



Major Takeaways


  • Without the need to short any assets, inverse ETFs enable investors to profit from a falling market.

  • Inverse exchange-traded funds (ETFs) are created for speculative traders and investors to execute tactical day trades against their underlying indices.

  • For instance, an inverse ETF that replicates the Standard & Poor's 500 Index's inverse performance would indicate a loss of 1% for every 1% gain in the index.

  • Due to the nature of their construction, inverse ETFs pose specific risks that investors should be aware of before investing.

  • Compounding  risk, derivative securities risk, correlation risk, and short sale exposure risk are the primary risks associated with investing in inverse ETFs.


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Compounding Risk


Compounding risk is one of the most significant hazards associated with inverse ETFs. Compounding returns are a factor with inverse ETFs held for durations longer than one day. An inverse ETF is a single-day investment whose aim is to provide investment outcomes that are one-times the inverse of the underlying index. The fund's performance is likely to diverge from its investment target over time.


Investors who desire to hold inverse ETFs for an extended time must actively manage and rebalance their investments to avoid compounding the risk.


For instance, the ProShares Short S&P 500 (SH) is an inverse exchange-traded fund that strives to produce daily investment returns before fees and expenses, inverse, or -1X, of the S&P 500 Index's daily performance. Compounding returns result in SH's returns being -1X those of the S&P 500 Index.


Compounding returns become intense during instances of extreme market volatility. Compounding returns lead an inverse ETF's investment outcomes for durations longer than a single day to deviate significantly from one times the inverse of the underlying index's return during periods of extreme volatility.


As an example, suppose the S&P 500 Index is trading at 1,950, and a speculative trader acquires SH for $20. The index ends 1% higher at 1,969.50, while SH ends at $19.80. However, the index finished down 3% the next day, at 1,910.42. As a result, SH ends 3% higher at $20.39. On the third day, the S&P 500 Index declines 5% to 1,814.90, while SH gains 5% to $21.41. 


Compounding effects are evident as a result of this high volatility. The index plummeted 9.3%. SH, on the other hand, climbed by 7.1 per cent.


Inverse ETFs involve a high degree of risk and are thus not appropriate for risk-averse investors. This ETF is best suited for educated, risk-averse investors who are comfortable with the risks associated with inverse ETFs.


Learn more about the types of risk involved in inverse ETF investing.


Watch the video to understand further.

Risks Associated with Derivative Securities


Numerous inverse ETFs give exposure through the use of derivatives. Since derivative instruments are considered aggressive investments, they subject inverse ETFs to additional risks, including correlation, credit, and liquidity. 


Swaps on indexes and exchange-traded funds (ETFs) are intended to replicate the performance of the underlying indexes or equities. Due to expense ratios and other considerations, such as the negative impact of rolling futures contracts, an ETF's performance may not completely mirror the index's inverse performance. 


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As a result, inverse ETFs that utilise ETF swaps often have a higher correlation risk. It may not attain stronger correlations with their underlying indexes than funds that use simply index swaps.


Additionally, inverse ETFs that rely on swap agreements face credit risk. As we are already talking about credit risks you might want to learn more about different financial risks. 


A counterparty may be unwilling to meet its obligations. It might result in a severe decline in the value of swap agreements with the counterparty.


 Due to the liquidity risk inherent with derivative assets, inverse funds that hold them may be unable to acquire or sell their holdings in a timely way or at a reasonable price.


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Correlation Risk


Correlation risk is also associated with inverse ETFs, which can be caused by various variables, including excessive fees, transaction costs, expenditures, liquidity, and investment strategies. 


While inverse ETFs aim for a high degree of negative correlation with their underlying indexes. These ETFs often rebalance their portfolios daily, resulting in increased fees and transaction costs associated with portfolio management. 


Additionally, rebalancing and reconstitution events may result in inverse funds being under-or over-exposed to their benchmarks. During the events, these variables may weaken the inverse correlation between an inverse ETF and its underlying index.


Futures contracts are exchange-traded derivatives that either have a defined delivery date for a specific quantity of an underlying security or settle for cash on a particular date. 


In the case of inverse ETFs that utilise futures contracts, funds roll their positions into less costly, longer-dated futures contracts during periods of backwardation. In contingent markets, on the other hand, funds move their jobs into more expensive, longer-dated futures.


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It is unlikely that inverse ETFs investing in futures contracts would have daily correlations entirely negative to their underlying indices. It is mainly due to the influence of negative and positive roll yields.


Short Sale Exposure Risk


Inverse ETFs may seek short exposure through the use of derivative instruments such as swaps and futures contracts, exposing them to the risks involved with short-selling assets.


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 The two primary risks associated with short-selling derivative instruments are a rise in overall volatility and a decline in the liquidity of the underlying securities of short positions. These risks may reduce the returns on short-selling funds, resulting in a loss.


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A Real-World Illustration of an Inverse ETF


ProShares Short S&P 500 (SH) offers inverse exposure to the S&P 500's big and midsize firms. It has an expense ratio of 0.90 percent and net assets of about $1.77 billion. 


The ETF is intended to be used as a one-day trading instrument and is not kept for an extended period. The S&P fell in February 2020, and as a result, the SH increased from $23.19 to $28.22 by March 23, 2020. If investors had been in the SH at the time, they would have reaped the benefits.





Here's a deeper look at how inverse exchange-traded funds function. As with standard ETFs, reverse ETFs are a group of assets that track a specified index. The primary distinction is that ETFs profit when the market rises, but inverse ETFs profit when the market falls.


While inverse ETFs are dangerous, they may attract investors looking for a less expensive alternative to "short" a company. Additionally, they can assist investors in hedging while investing in regular ETFs.

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