How an Inverse ETF Works -- SmartAsset

While a typical exchange-traded fund (ETF) lets you invest in a sector, index or industry, an inverse ETF lets you bet against them. Inverse ETFs see gains when a market or index goes down. They can be less risky and less expensive than shorting stocks, but they can also be somewhat more costly than standard ETFs. After you find, evaluate, and invest in inverse ETFs, you can just sit back and wait for the sky to fall. For help with inverse ETFs and all other investing questions, consider working with a financial advisor.

Inverse ETF: Definition

Inverse ETFs, also known as short ETFs or reverse equity ETFs, get their name by taking the opposite position of traditional ETFs. A traditional ETF allows you to invest in a collection of securities tied to an existing index, such as the SPDR S&P 500. If the index rises, investors in the ETF tracking that index makes money.

Inverse ETFs, however, make money when the price of those stocks goes down. By using derivatives, including futures contracts such as commodity futures, an inverse ETF allows you to bet on the decline of a market or index. If the market falls, an inverse ETF rises by a similar percentage (minus broker fees and commissions).

Since derivative contracts are bought and sold daily by fund managers, inverse ETFs are short-term investments. That frequent trading makes them somewhat costly, with expense ratios of 1% or more. They also rebalance daily, making them complicated for novice investors.

Meanwhile, a leveraged ETF uses derivatives and debt to enhance the returns of an underlying index. Where an ETF’s price rises or falls at a level equal to the index it tracks, a leveraged ETF boosts returns by two- or three-to-one compared to the index.

Leveraged inverse ETFs try to provide the same enhanced returns when a market falls. Thus, a leveraged inverse ETF tied to the S&P 500 can deliver up to a 4% return if that index falls by 2%.

Inverse ETF Discovery

Here's a closer look at inverse etfs and how they work.

Inverse ETFs can be risky, so it pays to do your due diligence. There are inverse ETFs associated with many existing indexes, with ETF providers like ProShares and Direxion offering a variety of them.

While there are comprehensive lists of some of the best ETFs on the market, several variables should influence your decision. Your risk tolerance, your current holdings and your knowledge of current market trends all factor heavily.

You can track the performance of the inverse ETF you’re considering, but it doesn’t hurt to consult your broker. You may even consider leaving the inverse ETF investing up to the professionals, as it can be a risky move for novices due to these funds’ daily rebalancing.

Inverse ETF Pros and Cons

An inverse ETF allows investors to essentially “short” a stock, without taking on many of the risks of that action. Shorting often requires investors to use a margin account with their brokers to buy and sell shares. If the price of a security rises above the agreed-upon margin price, the investor is liable for the cost. Shorting also requires a stock loan fee of up to 3%.

Inverse ETFs often have expense ratios of less than 2% and can be purchased by anyone with a brokerage account. That’s a higher ratio than traditional ETFs, but can still be less costly than shorting.

Inverse ETFs can also hedge against more positive holdings in a portfolio. If an overall portfolio contains several ETFs tied to an existing index, an inverse ETF tied to the same index can provide protection if the market falls. If that market rises, investors can sell inverse ETFs to prevent losses.

Inverse ETFs can still be risky investments just because of their speculative nature. If an investor bets on a market or index going down and it goes up, that investor can take a loss. If a leveraged inverse ETF promises two-to-one returns, it can also yield two-to-one losses should the market climb.

The Bottom Line

Inverse ETFs, like their traditional counterparts, are a collection of securities that track a specific index. The one major difference? ETFs bet on the market going up, while inverse ETFs make money when the price of these securities goes down. While risky, inverse ETFs can be an avenue for investors wishing for a less expensive way to “short” a stock. They also can help investors hedge while simultaneously investing in traditional ETFs.

Investing Tips

If you aren’t sure if an inverse ETF is right for you, you can consult a financial advisor. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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