What Are Inverse ETFs and How Do They Work?

While some investors believe markets have nowhere to go but up, some have a different take, and they want to profit from the sudden jolts that markets invariably experience.

One way they do this is with what are known as inverse ETFs, which are cousins of exchange-traded funds, or bundles of various funds and securities that rise or fall in value alongside a particular index. But instead of rising when markets gain, inverse ETFs  profit when they fall.

Some investors turn to inverse ETFs to reduce losses when markets fall, while others use them purely for speculation. Here’s a look at what inverse ETFs are, how they work, and what type of investor might consider them.

What are inverse ETFs?

An inverse ETF, often known as a bear or short ETF, is an exchange-traded fund designed to profit from a market decline. These short-term, publicly traded investments are utilized by investors who believe that a particular market or individual security will lose value in the near future. They may use inverse ETFs as a way of hedging losses during a downturn.

“Inverse ETFs are a tool to hedge a stock portfolio,” explains John DeYonker, Head of Investor Relations at Titan. “If the S&P 500 is your benchmark, and it goes up 1%, then your hedge will go down 1% and vice versa. Hedging with inverse ETFs can reduce volatility for investors—it’s like insurance.”

Investors may also use inverse ETFs as a way to take advantage of a predicted decline. In this way, they may be used as an alternative to short selling. For example, if an investor believes that the oil industry will have a setback in the immediate future, they may choose to purchase an inverse ETF of securities tied to energy producers. If correct in their prediction, the investor’s inverse ETF may recognize a profit. If the investor is incorrect, and the market or individual security increases in price, they may see a loss.

An investor who believes that the S&P 500 will decline, for example, may choose to purchase shares of the ProShares Short S&P 500. This inverse ETF’s value is inversely proportional to the overall S&P 500 index.

Inverse ETFs are generally considered to be highly volatile investments, as their losses typically compound daily. This makes inverse ETFs more risky than the index to which they are tied.

On the topic, if you're curious about how compounding could potentially affect your investment returns over a period of time, check out Titan's Compound Interest Calculator.

How do inverse ETFs work?

Inverse ETFs use derivative contracts—such as options, forwards, swap agreements, or futures contracts—to build a portfolio of securities that perform in opposition to a specific index or asset.

A futures contract is a legal agreement that an investor makes to buy or sell a particular asset at a specific price or even time in the future. Futures contracts act as a placeholder for the investor, creating a contract to purchase or sell specific investments once those assets reach a predetermined price. These agreements can also be used to automatically buy or sell investments at a future time.

What are leveraged inverse ETFs?

An inverse leveraged ETF is designed to not only perform in opposition to a specific index, market, or security, but to do so according to a specific gearing ratio, or multiplier. This means that an investor can recognize amplified returns—or losses—depending on the focus investment’s performance.

So, where does the name come from? These investment vehicles use leveraged (or borrowed) funds to purchase the futures contracts in the portfolio, which enables them to offer these outsized returns to investors. However, this strategy also means the potential for outsized losses.

Take the Direxion Daily Technology Bear 3X Shares ETF. This leveraged inverse ETF is focused at the Technology Select Sector Index, within the tech sector. It is designed to provide 300% annualized returns based on that index’s performancein a single day; if the Technology Select Sector Index has a daily decrease of 2%, this inverse leveraged ETF will increase 6% as a result.

However, investors can also experience amplified losses with a leveraged inverse ETF. If that same tech index has a 2% gain in one day instead, investors holding the inverse leveraged ETF will recognize a loss of 6%. Its sister ETF, the Direxion Daily Technology Bull 3X Shares ETF, rises and falls threefold in tandem with the same tech index.

Inverse ETF vs. short selling

Short selling is another investment strategy designed to take advantage of a price decline of a specific security or a broader market downturn.

Let’s say an investor borrows 50 shares of stock from a broker, which are priced at $100 each ($5,000 total). The investor sells the borrowed stock at the going price and receives $100 per share.

If share prices then drop to $80, the investor can purchase them for $4,000 and return the borrowed shares to the broker. The investor then pockets the $1,000 difference as a profit (though some added costs may reduce the profit).

Both inverse ETFs and short selling have the same intention: profit from speculating when certain markets or securities will decrease in price. Both offer the potential for high rewards, but also pose a significant risk if that predicted downturn does not occur.

The biggest difference between inverse ETFs and short selling is that short selling requires investors to hold a margin account. This account is used when the broker lends funds to the investor. A stock loan fee is also charged to the investor in exchange for the loan, which increases the cost (and risk) of short selling. There’s one other risk to short-selling: markets, over time, tend to rise more than they fall.

Advantages of inverse ETFs

Inverse ETFs are generally regarded as high-risk-high-reward. For sophisticated investors, these short-term investments may provide a number of advantages.

• Gains may be amplified, exceeding the underlying index

  . When investing in a leveraged inverse ETF, investors are able to amplify their potential returns by a specific multiplier. If the underlying index decreases in price, the investor recognizes an oversized return.

• A wide variety of securities are available

  . As of November 2021, there were 88 inverse ETFs to choose from within the US markets. The inverse ETFs list includes asset classes such as equity, fixed income, commodities, and alternatives.‍

• They can make money even when the market declines

  . Investors may use inverse ETFs to recognize profits even when the overall markets or certain asset classes are declining.

Risks of investing in inverse ETFs

With that said, there are many risks of investing in inverse ETFs. These short-term investment vehicles are generally regarded as highly volatile and may require constant monitoring. They are often reserved for more experienced investors.

Some of the most notable risks of investing in inverse ETFs include:

• Losses may compound

  . Most inverse ETFs are based on daily returns. For this reason, if an inverse ETF is held for more than a day, the growth (or losses) will compound. Depending on how the performance is spread out, the inverse ETF may not precisely mirror the index, which can be detrimental to an investor’s recognized growth.

• Short sale exposure increases volatility and risk

  . If derivative securities are utilized, an inverse ETF’s overall risk is amplified. Not only can this make the investment less liquid, but it can also increase volatility and potentially decrease gain.

• Derivatives can amplify risk

  . Many inverse ETFs use derivatives to provide additional exposure. While these securities can potentially drive returns, it also exposes the investment (and ultimately, the investor) to added credit risk, correlation risk, and liquidity risk.

• Correlation risk can affect returns

  . An inverse ETF’s profitability is highly impacted by correlation risk. This includes factors like illiquidity, broker fees, transaction costs, and other expenses.‍

• Gains may be taxed as ordinary income

  . Leveraged ETFs are held for a short period of time, so any profit is typically considered short-term gain. Short-term gains are taxed as ordinary income, which is higher than the tax rate on long-term gains. This may increase an investor’s overall tax burden and risk.

The bottom line

Inverse ETFs are usually used by investors as a way to speculate in opposition to movements in markets. Some sophisticated investors turn to them to hedge against a decline in value of a specific asset class or index, profiting when prices fall. Inverse ETFs can, however, be riskier than holding securities directly.

For the most part, they are not designed to be long-term investments. And because many of them use leverage, their gains or losses can be amplified relative to the assets or index they target.