DIY investors who choose to get a share of the markets by including exchange-traded funds (ETFs) in their portfolios generate returns when stock markets rise. But what happens when markets pull back and fall?
Inverse ETFs are structured to deliver the opposite of the daily performance (negatively correlated) of their underlying benchmark index. These funds, also called short ETFs or bear market ETFs, are what you choose when you want to bet against the markets.
DIY investors can utilise inverse ETFs to profit from market declines or hedge against portfolio losses. They also offer an alternative to traditional short selling, which requires a margin account and entails specific risks and management costs.
However, these complex financial instruments are best suited for short-term strategies, as daily rebalancing and compounding can introduce tracking errors over longer periods.
How Inverse ETFs Work
These funds achieve their inverse results by using derivatives, such as futures, options, and swaps, rather than holding the actual assets.
Instead of short-selling underlying stocks, the ETF issuer enters into contracts that pay off when those stocks go down.
The fund’s managers adjust these positions every day to match their target. For example, if the aim is to move in the opposite direction to the S&P 500 (VOO-NASQ), they’ll recalibrate each day to maintain that inverse relationship.
The Issue With Daily Calibration
Because these funds are reset every day, holding them for longer periods can result in more pronounced losses over time due to the impact of compounding.
For example, if the S&P 500 drops 5% in a day, your inverse ETF gains 5%. If the S&P 500 then rises 5% the next day and your inverse ETF drops 5%, many investors mistakenly believe that they are back to even.
That is an incorrect and potentially risky assumption because a 5% gain followed by a 5% loss doesn’t equal zero. When this happens, your investment and the market end up slightly down over the period because the 5% gain is calculated from a reduced total following the previous day’s loss. This effect becomes more pronounced over time, especially in choppy, volatile markets.
Pros:
- Downside exposure: Profit from market declines without the complexity of short-selling stocks.
- Avoid margin calls: You can only lose what you invest, unlike traditional short selling.
- Portfolio hedging: Provide temporary protection for your long positions during expected downturns without having to sell holdings you want to keep.
- Liquidity: Most inverse ETFs trade throughout the day just like regular stocks, so you can get in and out quickly.
- Access to specific sectors: Bet against specific industries or sectors, like tech or energy, rather than just broad markets.
- Transparency: You know exactly what the fund is trying to do.
Cons:
- Daily reset decay: The compounding effect can erode returns over time.
- Not a long-term strategy: As markets historically rise over time, inverse ETFs are only suited for short-term tactical trades.
- Higher costs: Typically cost more than regular ETFs due to the derivatives and active management involved.
- Complex: You need to be right about both direction and timing.
- Tracking errors: The fund might not perfectly match the inverse of its benchmark, especially over multi-day periods.
When to Use Inverse ETFs
Given the daily calibration, inverse ETFs are primarily used by day traders who want to profit from expected market drops over a few hours or days.
Investors who want to protect their portfolios from short-term declines without selling their long-term holdings can also consider inverse ETFs to hedge their positions.
However, their complex nature and need for constant monitoring mean inverse ETFs are generally not suited to novice DIY investors. These sophisticated tools are also designed for short-term, tactical use, not those looking to build long-term wealth.
These funds also tend to have higher fees than regular ETFs because of the complex derivatives they use.
