What Is an Inverse ETF and How Does It Work?

An inverse ETF is a specific type of exchange-traded fund that gains when the performance of the index it tracks declines. Inverse ETFs typically aim to deliver the opposite of the index’s daily return.

Inverse ETFs rely on derivatives, such as index futures, to ensure inverse exposure. Also, please note that Inverse Exchange Traded Funds (ETFs) are not permitted in India as per the Securities and Exchange Board of India (SEBI) regulations.

What Is an Inverse ETF?

An inverse ETF is a type of ETF that gains whenever the index it tracks experiences a decline in its performance. For example, if you hold units of a Nifty 50 inverse ETF, then you will make a gain when the Nifty 50 index loses points. It is usually built with derivatives like futures contracts, swaps, options, and more. Among these, swaps and index futures are the most common. These ETFs are also known as bear ETFs or short ETFs. In this case, a market gets the bear tag when it witnesses declining prices. 

How Do Inverse ETFs Work?

Here are some key points about the working of these funds -

• Inverse ETFs rely on derivatives to target inverse daily index returns
• They typically invest in daily futures. They generally hold total return swaps and/or index futures as required to ensure target exposure. 
• The fund maintains positions which can generate approximately minus-1x of the underlying index’s movement during the day. In other words, a 1% decline in the underlying index would result in the inverse ETF gaining 1% and vice versa. These returns over multiple days vary due to compounding.
• They are primarily short-term investments as they are based on futures contracts and other derivatives that are traded daily. 

When Should You Use an Inverse ETF?

You can consider buying an inverse ETF if you believe that the market is gearing up for a sell-off. These investments may also be considered in case you want to hedge your existing portfolio positions against any possible losses.

For example, if you witness economic fluctuations and instability in the market, inverse ETFs could help with tactically hedging with short-term views. However, please note that they are not a set-and-forget capital preservation tool.

Be aware of the daily reset, as it may create timing constraints. These funds are best for a short-term investment with careful tracking at your end. If you are certain that any specific sector will witness a near-term decline, you can buy sector-specific inverse ETFs. 

This may help you capitalise on the expected downturn. However, these investments may not always work well for the long haul. The daily compounding effect may cause these funds to diverge from the expected returns over longer durations. You should not take on these investments if you’re looking at a conventional buy-and-hold strategy.

At a basic level, you can hedge against the regular ETFs in your investment basket. For example, if you have conventional ETFs that track benchmark indexes, you may pair inverse exposure tactically with prolonged exposure.

However, the effectiveness of your hedge can decline over multiple days due to compounding and other costs. And there is no assurance that they can fully offset any losses over periods longer than a day. This is a good way to adopt a short position on an index without the need to sell or borrow assets.

You can diversify your portfolio by adding assets that negatively correlate with the market. These ETFs also have lower expense ratios than hedge funds. They also offer multiple options to sync with your risk appetite and investment objectives. 

Types of Inverse ETFs 

Here are some types of inverse ETFs -

• Broad market - These ETFs track indices such as the S&P 500 and NASDAQ 100, which have inverse performance. 
• Sector-Specific - They offer exposure to several target areas in the market. These sectors may include finance, energy, technology, and so on. 
• Leveraged - They strive to deliver multiples (2x or 3x) of the inverse return on any index. While they offer higher returns, their risk quotient is also higher. To take an example, if the Nifty 50 loses 3%, your 3x leveraged ETF will gain by 9%.

Inverse ETFs vs Short Selling 

Here is a round-up of the differences between ETFs and short selling - 

Risks Associated with Inverse ETFs

Knowing about the risks of inverse ETF investments is essential before you finalise your decision. Here is a closer look at the same. 

• Higher Risks

  These ETFs may lead to considerable losses if the market moves in the opposite direction of your expectations. Using leverage in these funds may amplify not only your gains, but also losses. Also, these ETFs may witness tracking errors and may not always replicate the underlying index performance accurately. Factors like liquidity hurdles, rebalancing costs, fees, and market disruptions come into play in this case.

• Short-Term Focus
  

  Inverse ETFs are tailored for short-term trading and reset exposure to the index daily. Holding them for longer durations may lead to losing their desired correlation with the index in question. 

Who Should Avoid Inverse ETFs

As mentioned earlier, they are avoidable options if you rely on the conventional buy-and-hold strategy for assets.

If you cannot take the risk of short-term and strategy-oriented trading, consider avoiding these investments. You will need to monitor them daily while being open to the scope of amplified gains and losses alike.

If you cannot take on these risks and dedicate ample time to tracking inverse ETFs, consider staying away from them. These ETFs are better choices for experienced market traders. 

Conclusion

Inverse ETFs may help you potentially hedge against falling markets or gain from them. You can do this without resorting to conventional short-selling. While they may help cushion your portfolio amidst any anticipated downward fluctuations, the daily reset system needs regular tracking. If you are investing in these ETFs, make sure you check the leveraged or unleveraged aspect and expense ratios. It is a better short-term bet, and you should ideally avoid any long-term manoeuvres in this case.