Sometimes, opposites attract on Wall Street and so it goes with the inverse exchange-traded fund.
Inverse exchange-traded funds (ETFs) pay a return when the index or benchmark it tracks is inverse against that benchmark.
At first glance, picking assets that go in opposite directions isn’t easy, especially given the fact that the trading formulas used to leverage inverse ETFs count on highly volatile investing tools like short selling and futures contracts.
Maybe that’s why inverse exchange-traded funds aren’t meant for the Main Street investors. But if you’re looking for a robust return by doing the opposite of what most other investors are doing, then taking the inverse ETF path could be an option for you.
Inverse Exchange-Traded Funds Defined
An inverse exchange-traded fund aims to generate positive investment returns by leveraging derivatives to gain steam when an underlying market index underperforms.
If you’re familiar with stock market short-sales then you’re getting closer to the real definition of an inverse ETF.
A short sale occurs when an investor borrows securities from a broker-dealer or other stock owner and sells them right away.
The goal is to buy those same shares back at a lower price when the underlying stock declines, thereby locking in a profit after repaying the stock lender. In essence, the short sale investor is betting that the stock he is borrowing will decline in price, with that investor pocketing the difference in price once both transactions are completed.
In essence, inverse ETFs work that way, too, only with futures and options contracts as the transaction driver, and not stocks. Those contracts, traded daily, enable investors to buy or sell a security at a specific time and at a specific price. In the case of an inverse, the investors buys an inverse exchange-traded fund tied to a derivative contract, based on an underlying benchmark or index.
This happens more than you might think. In 2008, right after the U.S. stock market free fall, the ProShares Short 500 Inverse ETF rose by almost 39% for the year.
Yet if that benchmark declines in value, the inverse ETF will do the opposite and climbs by an approximate equal value, generating a market gain for the investor, after he pays any commissions or fees tied to the transaction.
Of course, if the investor bets on the wrong horse, and the market benchmark rises, the inverse ETF will decline in value, and that investor is out of luck.
Short-Term vs. Long-Term
Typically, inverse ETF trades are short-term in nature, usually on a daily basis, as the investor aims to move in quickly to leverage a near-term decline in a specific index to make money. Waiting an index out, performance-wise, over a longer period of time is not the idea – it’s to leverage options and futures contracts on a daily basis that can pay off immediately when the underlying benchmark falls within the period the derivative is active.
For example, let’s say an investor steers some cash into an inverse exchange-traded fund based on the Standard & Poor’s 500 Index. If the S&P 500 falls by 1%, then the inverse ETF that tracks the index will gain 1%, based on the derivatives used to play the contrarian game.
That’s a trade made on a daily basis.
If the same investor was counting on the inverse ETF based on the S&P 500 to move reliably over a week or month, then the scenario grows murky. Mixing options and futures contracts with major market indexes over the long term leads to wider and more unpredictable investment outcomes, mainly due to compounded gains and losses and changing ETF prices.
That “short-term” approach to inverse ETFs is by design. It’s meant to take advantage of quick market swings, especially declining stock prices. It’s much easier to accurately leverage benchmark swings over a short-term period (say, one day) than it is to do the same over a longer period of time (say, one month.)
Pros and Cons of Inverse ETFs
Like any investment vehicle, there are upsides and downsides to inverse ETFs.
Pros of Inverse ETFs
Betting on a fall. Having a way to make money when the stock market decline isn’t good for the market — or for most Main Street investors – but it is highly useful if you’re convinced the stock market will decline, and you have a way to make a buck or two off that decline.
A good defense against market declines. Any savvy investor wants a decent hedge against severe market conditions, and inverse ETFs can deliver the goods in those downscale market scenarios. Let’s say you’re long in stocks and funds linked to the S&P 500. If you want to protect against bad news, like a potential pandemic or a significant military conflict in the Middle East, a substantial investment in an inverse stock market ETF can provide big returns if the stock market goes south.
Plenty to choose from. There are over 100 inverse-exchange-traded funds to choose from, so there’s no lack of options - from small cap funds to gold funds. So choose well and choose wisely.
Cons of Inverse ETFs
Compounding can work against you. When you own stocks or funds, or even if you save cash in a bank account, compound interest works in your favor, as money reinvested means more money gained over the long haul. That’s not the case with inverse ETFs, where compounding can work against the borrowing aspect of asset shorting models – particularly in fast-moving, volatile financial markets.
For example, any long-term big bets against the S&P 500 over the last five years, where compounded returns would have accumulated significantly, would have also led to big losses in an S&P-linked inverse ETF.
Other elements of risk. For unwary investors, a significant risk of losses exists if investors steer too much cash into inverse exchange-traded funds, and who make the wrong call on entry points and durations levels.
High fees a problem. The daily trading model used by most inverse exchange traded funds can be a major trigger. That’s because the funds are tracked and adjusted on a daily basis, which leads directly to higher management fees, which are passed on to investors.
Traditional exchange-traded funds don’t trade as frequently, and thus have much lower fund management fees.
The Takeaway on Inverse Exchange-Traded Funds
If you’re an investor looking for a short-term contrarian play or are simply looking for a solid hedge against a downward market, an inverse exchange-traded fund could be a good idea.
Just don’t hang on to these volatile ETFs too long. The more the days roll by as an inverse exchange-traded fund owner, the more risk you’re taking of losing, rather than making money in ever-changing financial markets.