What is an Inverse ETF?

Usually ETFs and mutual fund values tend to track or outperform a benchmark index. However, there is something known as inverse ETF which tries to do quite the opposite of this very activity. Inverse ETF is a type of exchange-traded fund which is traded on the public stock exchange and which has an underlying benchmark. This type of ETF has several derivatives in its portfolio and it is designed to profit from a decline in the value of its benchmark index. In a way, an inverse ETF is designed to perform as the inverse of the underlying index it tracks.
 

Also known as “Bear ETF” or a “Short ETF,” several strategies such as short selling, futures contracts, and other leveraged investment techniques are used in inverse ETFs. Essentially, when the stock market and indices fall, the prices of inverse ETFs rise and investors holding such ETF units in a bear market usually earn profits. Read more to find out how inverse ETFs work, benefits and risks associated with inverse ETFs, how to invest in inverse ETFs using Bajaj Broking, and a quick comparison between inverse ETFs and short-selling.

How Inverse ETFs Work?

In the world of investing, investing in ETFs and stocks are not without risks and rewards. Let us understand how ETFs work and then it would be easier to understand inverse ETFs. A traditional ETF usually tracks the market index. For instance, a NIFTY 50 ETF tracks NIFTY 50. An investor who holds several units of that NIFTY 50 ETF would like the value of NIFTY 50 to increase. When the value of the index does increase, it also results in an increase in the value of the constituents that the investor is holding and he may sell the units at a profit.
 

Inverse ETFs, on the other hand, are diametrically opposite to how traditional ETFs work. Whenever the price of the index goes down, the inverse ETF units gain in value. So, if an investor knows about a slowdown in the market beforehand, he can experience profits if he buys inverse ETF units before the market slump. In a way, inverse ETFs offer protection against short-term market volatility through various derivative instruments such as swaps, and futures & options among a few others. 
 

A key point to understand in the context of an inverse ETF is futures contracts. A futures contract is a contract between two parties to purchase or sell any financial asset at a fixed time and price. So, these types of contracts allow investors to bet the direction of the price of a stock. Inverse ETFs are actively managed and the fund manager enters into a contract armed by his analysis that the overall market will see a slump. When the market actually decreases, the fund manager can buy those derivative instruments at a lower price than he sold it for and makes profits from the difference. Inverse ETFs are meant for investors who are comfortable with futures contracts and are not suitable for those who are looking to hold such assets for more than a day. 

Benefits of Investing in Inverse ETFs

There are significant benefits of investing in inverse ETFs as mentioned below 
 

1. Hedge against downturn

   Inverse ETFs serve as a hedge for investors when the market is bearish. As an investor, if you think that a particular sector or theme will soon experience a decline, then you place orders to buy inverse ETF units. And, when you think that the dry phase of the market has reached bottom, you simply sell those units. Though a risky strategy because an investor still needs to predict a market decline and bottom, inverse ETFs serve as a hedge against a bear market.

2. Simplicity

   As an investor, you can easily invest in an inverse ETF by simply buying ETF units. You do not get into contracts and agreements but the fund management professional does that on your behalf. So, investing in an inverse ETF is a simple way to experience profits from futures contracts without actually executing one!

3. Cost-effective

   Since the fund manager executes contracts on your behalf when you invest in an inverse ETF, you do not need to open a margin account. This is because short-selling requires borrowing of margin money from your broker and in an inverse ETF, your fund manager executes the contracts on your behalf. Also, you do not need to open a futures and options trading account. All these result in cost savings for an investor. 

4. Access to investment expertise

   Short-selling is risky and it requires a lot of expertise to foresee the market position and taking short positions. An inverse ETF provides you access to professional fund management expertise because a fund manager executes those contracts on your behalf for a fund management fee. Therefore, even investors who are not experienced in futures and options can try investing in inverse ETFs knowing fully well that their fund is managed by an industry professional. 

Risks Associated with Inverse ETFs

Investors must be aware of the following risks associated with inverse ETFs - 

1. Compounding risk

   An inverse ETF has an objective for holding the investments only for a day and it tries to negatively replicate the returns of the underlying index. If the investment is held for more than a day, the performance of the ETF will differ from the one that is expected when the investment is held for only a single day. An investor who wants to hold his investments for more than a day in an inverse ETF must play an active part in rebalancing his portfolio for risk management.

2. Derivatives risk

   Inverse ETFs deal with derivatives which are considered risky instruments in investments. Derivatives bring with them several other risks such as credit risk, liquidity risk, etc. There is always a risk that one of the parties defaults on the derivatives contract. The movement of the market is unpredictable even by the most seasoned investors and this unpredictability gets amplified for derivatives. 

3. Correlation risk

   Even though the aim of investing in inverse ETFs is to exactly provide negatively correlated returns on the underlying index when the market is bearish, this does not always happen. The profits for investors get reduced by heavy transaction costs, high fees, and other expenses. Inverse ETFs are actively managed by the fund managers and this rebalancing may cause those ETFs to be overexposed or underexposed in comparison to their benchmark indices thereby reducing the likelihood of perfectly negative correlation.

4. Short exposure risk

   There is always the risk of market volatility coupled with market illiquidity. These risks decrease the level of profits expected from inverse ETFs during a market decline. 

Who should buy an Inverse ETF?

An important point to note is that inverse ETFs are not for investors looking to appreciate wealth in the short-term, mid-term, or long-term. Rather, these are for traders looking to realize profits in a day. Investors who are not comfortable with the “investing for a day” philosophy may find inverse ETFs unsuitable for their purpose.

Investors who understand market volatility and have the risk appetite to absorb heavy losses can also invest in an inverse ETF. He must be well aware of the process of short-selling, futures contracts, derivatives, and swaps. Someone with a lower risk appetite may consider traditional ETFs or mutual funds. Experienced investors who would like to diversify can also consider inverse ETFs as a possible alternative. Investors who are willing to bet on a declining market but do not want to take the risk of executing futures contracts themselves may also consider investing in inverse ETFs. Also, inverse ETFs suffer from high tracking errors and an investor must be comfortable with this aspect before putting his capital in an inverse ETF. Lastly, inverse ETFs have higher expense ratios and other expenses and a regular investor who wants to hold his money for a long term may find those expenses higher than the average.

Comparison: Inverse ETFs vs. Short Selling

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