What is an Inverse ETF?

Inverse ETFs are a class of ETFs that rises in value when their underlying asset falls. For example, the ProShares Short QQQ ETF (whose underlying asset is the NASDAQ) will rise, if the NASDAQ falls. So, if you expect companies in the NASDAQ to perform poorly, you could buy the ProShares Short QQQ. Recently, Inverse ETFs are gaining in popularity because the overall sentiment of the market is bearish, and everything seems to be going down (except the unemployment numbers).

Types of Inverse ETFs

Although Inverse ETFs are a relatively new phenomenon, there are already many Inverse ETFs that cover almost all major indices and sectors. This means you can pick a class that you are bearish on, and buy an appropriate Inverse ETF. For example, if I think that the financial sector is doomed, and I want to go short on the whole sector, I can buy the ProShares UltraShort Financials ETF, which bets against the Dow Jones U.S. Financial Index.

Similarly, there are other ETFs that short the Consumer Services Sector, Industrial Sector, Technology Sector, Oil and Gas Sector and also other classes like Emerging Markets, etc.  You name it, they have it.

Inverse ETFs Can Be Leveraged

Thanks to Lehman, leverage is no longer a financial jargon, but has entered the lexicon of the common man. Many Inverse ETFs are leveraged and aim to return twice or thrice the fall in the index value. For example, ProShares UltraShort Financials ETF gains 10%, if the underlying Dow Jones Financials index falls by 5%. The ETF will gain twice the amount that the index falls, and vice versa.

One way of doing this is by employing leverage.  However, this is quite dangerous because the risk of counter party default is very high in today’s economy. And there’s also a bigger risk with leverage when combined with another phenomenon known as Daily Returns.

Inverse ETFs Seek Daily Returns

Daily Returns mean that the fund value at the end of each day becomes the base value of the next day. Suppose, you invest in an UltraShort Inverse ETF, which aims to return twice the fall of the underlying index, a hypothetical situation can look something like this:

Day Index Inverse ETF
1 100 100
2 95 (down 5%) 110 (up 10%)
3 100 (up 5.26%) 98.42 (down 5.26 x 2 = 10.52%)

Basically, the index didn’t move at all after three days, but you lost money! I have taken an example in which the ETF loses money (just to drive home the point), but you can make money with zero change in the underlying index in a given period as well.

Inverse ETFs Are Not Meant for Hedging

Be wary of using leveraged Inverse ETFs to hedge your position, because leveraged ETFs are not good for hedging as explained above.

Inverse ETFs Are Ideal for Short Term Trading

Inverse ETFs are best for short-term trading, if you have a bearish view on a particular segment in the market.

Some other benefits of Inverse ETFs:

  1. You can short the index, but are exposed to only the amount you invested in the ETF.
  2. You don’t need a margin account, which is normally needed to shorting.
  3. You don’t need to buy fancy options in order to take a bearish view of the market.
  4. You can take advantage of the volatility of the market.
  5. You can buy a leveraged Inverse ETF, and increase your odds of a large profit with a small loss.

Bottom line

If you have a bearish view of the market, and want to trade short-term this product is good for you.  However, if you shun volatility or if you are more of a long-term investor, then you should not dabble in this product.

About the Author

By , on Jan 27, 2009
Manshu is the owner of OneMint, a blog with the goal to create more financial savvy among people so that they understand and manage their own finances better and also get a better grasp of the global financial markets.

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Leave Your Comment (2 Comments)

  1. Pinyo says:

    @Manshu – thank you for your contribution.

  2. Manshu says:

    Thanks for allowing my post here!

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