How Inverse ETFs Work
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Inverse ETFs seek to deliver results that correspond to the inverse, or -100%, of the change in a related index over a specified period of time. Similar to leveraged ETFs, there are inverse ETFs that seek to deliver results over both daily and monthly time periods.
Due to the compounding of returns, the risk and return factors of inverse ETFs will often differ from the experience of simply selling an ETF short. Similar to leveraged ETFs, the performance of inverse ETFs held for longer periods of time than the rebalancing period will depend on the direction of the related index. Consider a daily inverse ETF that’s linked to an index that consistently appreciates (see table).
In this example, the index to which the inverse ETF is linked gains 21.9% during the time period in question. The losses incurred by the inverse ETF are only 18.3%. This occurs because the inverse ETF lowered its exposure after each losing session.
Selling an ETF short would hypothetically expose a client to unlimited losses, since a fund could theoretically experience unlimited appreciation. Achieving short exposure through an inverse ETF limits downside exposure, as the maximum possible loss is the amount of the initial investment.