Despite the proclamations and influence of some internet celebrities, stocks don’t always go up. One of the reasons stocks have provided consistent returns is the perpetual threat of a crash or bear market. If stocks never faced rough patches, there wouldn’t be long-term growth. As the famous saying goes: with no risk, there is no reward.
Bear markets and stock crashes might be inevitable, but that doesn’t mean we HAVE to lose money when they occur. Shorting stocks allow traders to profit from a decline, as do derivatives like put options. But a relatively new asset class called inverse ETFs allow traders to make money in declining markets without buying derivatives or borrowing shares. Inverse ETFs increase in value when their corresponding index declines, but they still carry unique risks that investors should be wary of.
What are Inverse ETFs
For many traders, short selling isn’t accessible. Borrowing shares costs money and carries significant risk should your thesis turn out to be untrue. But that doesn’t mean profiting off a decline in stock prices is out of reach for the retail investing crowd. You don’t even need to use derivatives like options or futures contracts – you can simply purchase shares in an inverse ETF that appreciates in value when its underlying stock index drops.
Inverse ETFs have a much different structure than traditional ETFs. The goal of an inverse ETF is to provide returns opposite of those provided by the underlying index or basket of securities. For example, an inverse ETF of the S&P 500 would rise in price should the major index suffer a decline. Sounds simple, right? But in reality, inverse ETFs are far more complicated than their traditional brethren and should not be used as the basis for a long-term investment plan.
How Do Inverse ETFs Work?
Inverse (or bear) ETFs can’t purchase common stock and hope to achieve their investment goal. In order to profit off a decline in an index, the issuer of an inverse ETF must buy a combination of options, swaps, or futures contracts to meet their objectives. No actual equity is owned in the basket of an inverse ETF, only derivatives that increase when the stock index declines.
It’s clear to see from this where a potential problem can arise. Derivatives like options and futures contracts are complex trading tools priced based on a variety of factors. The fund issuer must buy and sell these contracts on a daily basis in order to meet the investment objective of the inverse ETFs. The investment objective of an inverse ETF isn’t just to rise when certain stocks fall, but to match the DAILY returns of the underlying index in reverse.
For example, if the S&P 500 drops 1% in a day, you can reasonably bet that the inverse ETF tracking it will rise 1% that day. But if the S&P 500 drops 1%, then rises 0.5% the next day, then drops another 1% again the day after, you won’t have a return of 2.5% on your inverse ETF. Inverse ETFs decay over time due to their derivative-based structure, so unless the underlying index falls steadily each day, returns from these vehicles can be all over the place. Plus, compound interest works AGAINST you when trading these types of securities. Inverse ETFs are meant for short-term trading only – do not use these as long-term trading pieces.
Types of Inverse ETFs
- Broad Market: Inverse ETFs are used to profit from declines in a wide variety of different indices. The Dow Jones Industrial Average, S&P 500, NASDAQ Composite, and Russell 2000 all have corresponding inverse ETFs that rise when the market falls.
- Sector Specific: You don’t necessarily need to bet against the entire market to make money from inverse ETFs. Fund issuers like ProShares have inverse ETFs based on different sectors like Financials, Industrials, Utilities, Technology, and Healthcare.
- Leveraged: If you have a high risk tolerance, you may find appeal in leveraged inverse ETFs. Leverage is usually doubled or tripled, meaning a 3x inverse ETF of the S&P 500 would return 3% on a day that the index dropped 1%. Leveraged ETFs are subject to even more tracking error and time decay than unleveraged inverse ETFs, so extreme caution is warranted.
Inverse ETFs vs. Short Selling
Inverse ETF traders and short sellers usually have a similar investment thesis since both are hoping to profit off a decline in certain security. Both are attempting to reach the same destination with their trades, however, the risks and requirements to executing the trades are different.
Short sellers borrow stock from their broker to sell immediately. The broker will obviously want these shares returned at some point, so the short seller attempts to buy them back at a lower price and profit from the difference. But short selling requires a margin account and the risks are potentially unlimited since there’s no ceiling on the price of a stock. If you can’t find shares to cover your short in the middle of a squeeze, you could be looking at monumental losses.
Inverse ETFs are also risky, but you’re only risking the capital you put into the trade. Losses won’t exceed the original investment and you don’t need to borrow anything from your broker. Inverse ETFs can still blow up your account (remember XIV?) and they carry large expense ratios since fund managers must constantly sell their options or futures contracts and buy longer dated ones to meet their objectives.
Pros and Cons
Inverse ETFs are complex trading instruments and shouldn’t be traded unless you understand how they work. Remember, these ETFs aren’t for investing. They’re short-term trades for quick profits. If that doesn’t sound like something that fits your investment style, avoid these funds.
Pro: Make Money in Declining Markets – Should the market or underlying index decline, an inverse ETF matching the daily returns in reverse would prove to be profitable.
Con: Complex Derivative Instruments – Unlike simple index funds, inverse ETFs are built with derivatives contracts with pricing sensitivities different from the underlying securities of a traditional ETF. This can lead to big losses if you don’t understand the structure.
Pro: No Fees or Margin Required – To short stocks, you need to borrow shares (for a fee!) and have access to a margin account. Inverse ETFs can be purchased in cash accounts and the only fee attached is the fund’s expense rate.
Con: Not For Long Term Investing – Since inverse ETFs are structured with very specific derivative securities, they’re only ideal for very specific short term trades. Compound interest will destroy the investment of anyone who holds these ETFs long term.
Final Thoughts
Inverse ETFs can provide gains when markets are dropping, but they aren’t a sure thing. When derivatives like options and futures are involved, it’s never as simple as ‘number goes up when other number goes down. Inverse ETFs often have vague holdings and most people who buy them can’t really explain how they work. Of course, when has that ever stopped someone from making a trade?
Inverse ETFs may have a place in your trading plan as a short term hedge or a bet on a market decline, but holding these vehicles long term will lead to serious capital deterioration. And occasionally, you’ll run into an ‘event acceleration’ and your entire investment will go up in smoke. Inverse ETFs are unpredictable and shouldn’t be owned or traded unless you have a high risk tolerance.