Decoding inverse ETFs: Unveiling its advantages, and disadvantages

An inverse ETF is an exchange-traded fund (ETF) that enables investors to profit from a decline in a benchmark. Inverse ETFs deal with financial derivatives and are also known as Short ETFs or Bear ETFs. During periods of volatility, day traders may use these short ETFs as a way to reduce their exposure to or potentially even profit from downward market moves.

Investing in inverse ETFs is similar to holding various short positions that involve borrowing securities and selling them with the hope that they can be repurchased at a lesser price in the future. Inverse ETFs are not long-term investments as the derivative contracts are bought and sold every day by the fund's manager. Inverse ETFs produce their returns based on the daily change that takes place in the underlying security's value. If an inverse ETF is held for more than a day it can produce returns that do not match the total return of the underlying security. The primary goal of an inverse ETF is to generate gains for investors who predicted that the price of the underlying benchmark is declining and may continue to go downward shortly.

How do Inverse ETFs work?

Inverse ETFs use a variety of derivatives like swaps, futures, and options contracts to take short positions in the underlying index. Inverse ETFs gain as the price of the underlying index falls. Thus inverse ETFs have an inverse relationship with the index that it is tracking. As inverse exchange funds are traded daily, the fund manager buys feature contracts and bets as the market falls. The fund manager uses leveraging strategies such as short-selling or purchasing and selling futures contracts to achieve inverse returns.

Inverse ETFs do not require the investor to hold a margin account as in the case of short positions. Along with a margin account, short-selling an ETF also requires a stock loan fee that is paid to a broker for borrowing the shares to sell short while inverse ETFs often have expense ratios of less than 2% and can be purchased by anyone with a brokerage account.

Advantages of Inverse ETF

Higher returns: These Inverse ETFs have the potential to generate higher rates of return when the benchmark index loses its value.

Alternative to Derivatives: Inverse ETFs use financial derivatives, so this provides indirect access to them. Dealing in derivatives can be expensive but through inverse ETFs investors can make bets against a benchmark ETF or asset without buying futures or opening a margin account. 

Hedging: Investors can hedge against potential loss by purchasing shares of an inverse ETF that rises in price when the benchmark ETF falls in price.

Disadvantages of Inverse ETFs

Market risk: Investors will observe a decrease in price if the benchmark index or asset rises in price as the inverse ETFs produce an opposite return of a benchmark.

Long-term tracking: With the use of financial derivatives, Inverse ETFs track the returns of their benchmark daily, which may change over a longer period.

High fees: Inverse ETFs need to be managed on a higher degree so the expense ratios are higher as compared to traditional ETFs.

Moreover, investors can use inverse ETFs to gain from market declines in specific sectors or indexes. Inverse ETFs are complex instruments that can be used by active traders and not long-term investors. Inverse ETFs may also lead to losses in an upward-trending market that may cause risk if the market turns against you.