What Is an Inverse ETF? Everything You Need to Know

Inverse ETFs allow traders to benefit from price declines in a benchmark index or asset. Before investing, investors should learn how inverse ETFs work, as well as the pros and cons of holding these unique securities.

What Is an Inverse ETF? 

An inverse ETF is an exchange-traded fund that enables investors to profit from a decline in a benchmark index, asset or other ETF. For example, if the SPDR S&P 500 ETF Trust (SPY) goes down 1% on one day, you should expect the price of the ProShares Short S&P500 ETF (SH) to go up 1% the same day. 

Inverse ETFs may also use leverage to amplify their returns further, such as a 2x or 3x strategy. Thus, these inverse leveraged ETFs can produce higher daily returns in the opposite direction of a benchmark index, but the risk is also amplified. 

Some investors use inverse ETFs as a hedge against a decline in an ETF held in a portfolio, while others use inverse ETFs purely as a means of profiting from a decline in a benchmark. 

How Do Inverse ETFs Work? 

Inverse ETFs typically use derivatives, such as daily futures contracts, to produce their daily inverse returns. This introduces one of the primary benefits of inverse ETFs, which is that they allow investors to make bets that a benchmark will decline without having to directly purchase derivatives. 

Futures are a type of contract agreement to buy or sell a specific asset or security at a set future date for a specified price. In other words, a futures contract allows an investor to make a bet on the direction of price for a given commodity or security. In the case of inverse ETFs, the futures contracts held by the fund are betting that the price of the benchmark will go down. If successful, the shareholders of the inverse ETF will profit. But if the benchmark asset or security rises in price, the inverse ETF will decline. 

Types of Inverse ETFs 

Inverse ETFs can be found in the following asset classes: 

  • Equity 
  • Currency 
  • Fixed Income 
  • Alternatives 
  • Commodities 

Popular Inverse ETFs  

With 102 ETFs traded on U.S. markets, inverse ETFs have total assets under management of $6.37 billion. The average expense ratio is 1.04%. Popular ETFs, as measured by AUM, include the Direxion Daily Semiconductor Bear 3X Shares SOXS, with $1.15 billion in assets, followed by the Direxion Daily S&P 500 Bear 3x Shares (SPXS) and the Direxion Daily S&P 500 Bear 1x Shares (SPDN), with $933.97 million and $617.41 million in AUM, respectively. 

A popular inverse ETF that gained a lot of attention in 2022 is the AXS Tesla Bear Daily ETF (TSLQ), which is a single-stock ETF that seeks to produce the inverse daily performance of Tesla stock. 

Inverse ETFs vs Short-Selling 

One of the main advantages of inverse ETFs is that they allow an investor to bet on a decline in the price of a benchmark asset or security without having to buy derivatives or open a margin account. Without the use of an inverse ETF, an investor may achieve a similar strategy by short selling. 

To sell short, an investor opens a position by borrowing shares of a stock or other asset from the broker. The investor then sells that position in the market to other buyers. The plan is to buy the same stock later at a lower price, enabling the investor to profit after repaying the initial loan. Put simply, if the price of the security falls, the short seller profits, but if the price rises, the short seller loses. 

For the short seller, the cost of borrowing shares to sell short can reach or exceed 3% of the borrowed amount. However, many inverse ETFs have expense ratios lower than 2%, and can be traded easily with a brokerage account, without the use of margin. 

Pros and Cons of Inverse ETFs 

Inverse ETFs can provide investors with an alternative means of diversification or profit, but they also have unique risks that investors should understand. Therefore, it’s important to learn the pros and cons of inverse ETFs before investing. 

Pros of Leveraged ETFs  

  • Hedging: Investors can hedge against potential loss in a long position by purchasing shares of an inverse ETF that rises in price if the benchmark ETF falls in price.
  • Simple alternative to derivatives: Since inverse ETFs use financial derivatives to achieve their objectives, investors can make bets against a benchmark ETF or asset without buying futures or opening a margin account. 
  • Easy to trade: Like a traditional ETF, a leveraged ETF can be bought and sold like a stock on an exchange.

Cons of Leveraged ETFs  

  • Market risk: Since inverse ETFs are designed to produce the opposite returns of a benchmark, investors must be willing to see declines in price if the benchmark index or asset rises in price.
  • Long-term tracking: The use of financial derivatives enables inverse ETFs to track the returns of their benchmark indices on a daily basis, but they do not accurately produce the same results over longer periods of time. 
  • High fees: Compared with traditional ETFs, inverse ETFs require a higher degree of management from trading activity; therefore, their expense ratios are also typically higher. 

Bottom Line 

Inverse ETFs are short-term trading instruments that allow investors to profit when a benchmark index or asset declines in price. However, the unique structure of inverse ETFs also introduces significant market risk, especially if investors buy large positions or poorly execute their timing strategies. 

 

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