Lets understand Inverse ETF in details - Meaning, Advantages, Disadvantages, Types & Bottomline

Lets take deep dive in Inverse ETFs

What is an inverse ETF ?

An inverse ETF is an exchange traded fund (ETF) constructed by using various derivatives to profit from a decline in the value of an underlying benchmark. Investing in inverse ETFs is similar to holding various short positions, which involve borrowing securities and selling them with the hope of repurchasing them at a lower price.

An inverse ETF is also known as a "Short ETF" or "Bear ETF."

Inverse ETFs vs. Short Selling

An advantage of inverse ETFs is that they do not require the investor to hold a margin account as would be the case for investors looking to enter into short positions. A margin account is one where a broker lends money to an investor to trade. Margin is used with shorting—an advanced trading activity.

Investors who enter into short positions borrow the securities—they don't own them—so that they can sell them to other traders. The goal is to buy the asset back at a lower price and unwind the trade by returning the shares to the margin lender. However, there is the risk that the value of the security rises instead of falling and the investor has to buy back the securities at a higher price than the original margined sale price.

In addition to a margin account, short selling requires a stock loan fee paid to a broker for borrowing the shares necessary to sell short. Stocks with high short interest may result in difficulty finding shares to be short, which drives up the cost of short selling. In many cases, the cost of borrowing shares to short can exceed 3% of the borrowed amount. You can see why inexperienced traders can quickly get in over their heads.

Conversely, inverse ETFs often have expense ratios of less than 2% and can be purchased by anyone with a brokerage account. Despite the expense ratios, it is still easier and less costly for an investor to take a position in an inverse ETF than it is to sell stocks short.

Advantages

• Inverse ETFs allow investors to make money when the market or the underlying index declines.

• Inverse ETFs can help investors hedge their investment portfolio.

• There are multiple inverse ETFs for many of the major market indices.

Disadvantages

• Inverse ETFs can lead to losses quickly if investors bet wrong on the market's direction.

• Inverse ETFs held for more than one day can lead to losses.

• Higher fees exist with inverse ETFs versus traditional ETFs.

Types of Inverse ETFs

There are several inverse ETFs that can be used to profit from declines in broad market indexes, such as the Russell 2000 or the Nasdaq 100. Also, there are inverse ETFs that focus on specific sectors, such as financials, energy, or consumer staples.

Some investors use inverse ETFs to profit from market declines while others use them to hedge their portfolios against falling prices. For example, investors who own an ETF that matches the S&P 500 can hedge declines in the S&P by owning an inverse ETF for the S&P. However, hedging has risks as well. If the S&P rises, investors would have to sell their inverse ETFs since they'll be experiencing losses offsetting any gains in their original S&P investment.

Inverse ETFs are short-term trading instruments that must be timed perfectly for investors to make money. There's a significant risk of losses if investors allocate too much money to inverse ETFs and time their entries and exits poorly.

Double and Triple Inverse ETFs

A leveraged ETF is a fund that uses derivatives and debt to magnify the returns of an underlying index. Typically, an ETF's price rises or falls on a one-to-one basis compared to the index it tracks. A leveraged ETF is designed to boost the returns to 2:1 or 3:1 compared to the index.

Leveraged inverse ETFs use the same concept as leveraged products and aim to deliver a magnified return when the market is falling. For example, if the S&P has declined by 2%, a 2X-leveraged inverse ETF will deliver a 4% return to the investor excluding fees and commissions.

Bottom line

Inverse ETFs in one of the complex product available to investor in Developed market for maximizing return or hedge position but investor should entered these product based on risk appetite.