What is an Inverse ETF?
Demand for ETFs has exploded over the last decade as investors look for ways to get diversified exposure to a particular market, industry or even commodity as it takes the firm-specific risk out of the equation. But what is an inverse Exchange Traded Fund? Although going “long” (betting that the market will go up over time) is the most popular option for the retail investor, there is a growing interest in betting just the opposite – that is, wagering that the market will go downwards. Just like you can “short” a stock, you can also bet against a particular industry or stock exchange through a variety of inverse ETFs. The reason that we use the term “wager” rather than “invest” when it comes to shorting is because this form of trade comes with significant risk. In this article we hope to give some insight on just how inverse ETFs work and what risks they carry.
Inverse ETF will move in the exact opposite direction of whatever underlying market, industry, commodity or asset they track. Take for example the Australian BetaShares Equities Bear Hedged Fund – ticker symbol BEAR – that trades on the Australian stock exchange. This ETF will actually move in the exact opposite direction as the ASX 200 Index – so if the index drops by 5% this ETF will actually jump 5%! This provides investors with a way to profit in a declining market – or benefit from periods with high volatility provided you are an active day trader and can time your jumps in and out of the fund.
There is a catch though – the inverse ETFs generally seek to provide a return on a daily basis not on an absolute basis. What that means is that over time, due to compounding returns, the ETF will part from the underlying index. So in this example if over the course of a year the ASX drops by 20%, this ETF won’t drop by exactly the same amount. However, over a short-term period of a week or less you will generally get accurate returns. As a result, those looking to invest in inverse ETFs need to be careful that they don’t stay in for too long.
So why invest in an inverse ETF? If you feel the underlying asset is overvalued and is due for a correction very soon, an inverse ETF could yield excellent returns. The only challenge is predicting when exactly the market will turn on a particular asset. While the recent downturn in oil, for example, would have been extremely profitable for those who purchased inverse oil ETFs the fact of the matter is that very few experts saw it coming. Overall, inverse ETFs are more geared towards day traders. Those who are looking to bet against a company over the long run would be better off shorting the stock as this would provide more accurate dollar-for-dollar returns. As you can see, inverse ETFs are not the ideal investment vehicle for those who like to park their funny and re-balance their investments periodically.