Inverse ETF Basics
What are Inverse ETFs?
Inverse ETFs (sometimes called bear ETFs or short ETFs) are a type of exchange traded fund that aims to deliver the opposite return (-1x) of a certain index or benchmark over a specified period of time, usually one day. Inverse ETFs are a relatively small subset of the total ETF universe and are naturally more popular when the index it tracks is not doing well. You can clearly see inverse ETF volumes spike during heavy sell-offs. For the right investor or account, an inverse ETF can be viewed as an active management tool to hedge or reduce market risk in an investment portfolio. They may also be used opportunistically to take advantage of specific market opportunities.
There are several categories of inverse ETFs, including stocks, bonds, commodities and currencies. Most are considered single inverse ETFs, since they aim to track their benchmark, inversely, on a one-for-one (-1x) basis. But they may also be leveraged and inversely track their benchmark twice (-2x) or even three times (-3x).
How do Inverse ETFs Work?
An inverse ETF aims to return the opposite of a specified index or benchmark for a specified period of time (usually one day). For example, you think the market is overdue for a sell-off and are concerned about your existing (long) portfolio. You purchase inverse ETF ‘A’ which is a daily re-balanced, single inverse (-1x) ETF that specifically tracks the hypothetical ‘Market’ index and aims to return the opposite or inverse of the ‘Market’ index for that day. If the ‘Market’ index goes down 2% on Monday, then inverse ETF ‘A’ should go up 2% on Monday. Then the inverse ETF re-balances and the process begins again on Tuesday. Lets illustrate an example:
The Market Index level is, lets say, 100. Inverse ETF ‘A’, (which tracks the inverse, -1x, of the ‘Market’) had a starting price of, lets say, $50. On Monday, the Market goes down 2%. The Market index level then becomes 98 (original level of 100 minus the 2% loss or 100 x 0.98 = 98). Since the Market went down 2%, the inverse ETF ‘A’ went up 2% (ignoring any tracking error). Inverse ETF A’s price then becomes $51 (original price of $50 plus the 2% gain or $50 x 1.02 = $51). Then the process begins all over again for the next day from these new starting values (Market index of 98 and inverse ETF ‘A’ price of $51).
What are the holdings an Inverse ETF?
Unlike traditional ETFs which attempt to track a benchmark holding a basket of underlying securities or some other replication strategy, inverse ETF’s have no assets per say, it’s ‘holdings’ are actually derivatives. To understand inverse ETF basics, you must realize it is through the use of these derivatives (swaps, options and futures) that inverse ETFs aim to deliver the opposite return of their specific index or benchmark. The derivatives are contracts, or legal agreements, between two parties-the issuer of the inverse ETF and a counterparty, or several different counterparties. The counterparty is often a major financial institution who is obligated to deliver based upon specifications of the contract. Occasionally, the counterparty may be simply a trading desk in the issuers own firm in the case where the issuer and the counterparty are the same entity. Take an example of a hypothetical and simplified, swap agreement:
Inverse ETF ‘A’ aims to deliver the opposite return of the ‘Market’ Index on a daily basis. It enters into a swap agreement with counterparty ‘B’. Counterparty ‘B’ agrees to pay or receive the opposite return of the index (in our example above its the hypothetical “Market Index’) per day. If the Market Index goes down 2% on Monday, the Index ETF ‘A’ would go up by 2% and the actual return would come from the counterparty paying the amount to the inverse ETF, as per the agreement. Had the Market index gone up, the inverse ETF would have lost value and the inverse ETF would have been obligated to pay the counterparty the return. Counterparties often are required to post margin to satisfy such requirements.
Like all securities, there are benefits and risks to inverse ETFs and they may not be suitable for all investors. A suitability analysis should be performed by a financial professional. The daily reset feature may make inverse ETFs not a suitable intermediate or long-term investment, unless it’s part of a closely monitored hedging strategy.* We encourage you to learn more and see if they are right for your situation by speaking to your financial advisor who is familiar with your specific financial situation.