Inverse ETF Benefits
Still relatively new, inverse ETFs (sometimes called short or bear ETFs) are quickly becoming a go-to security in volatile times. During severe market sell-offs, we see inverse ETF volumes explode higher as investors rush to hedge current investments or speculate opportunistically. Designed for very short-term use (inverse ETFs are usually rebalanced daily), they’re optimally designed for day trading. Inverse ETF benefits include quick and cheap trading, allowing an investor the opportunity to benefit from declining stock prices. The ability to profit from market sell-offs was formerly only available to professional traders. Inverse ETFs can be viewed as a valuable tool in any tactical asset allocation strategy because they help reduce risk in an investment portfolio. There are several benefits to using inverse ETFs.
Hedging with Inverse ETFs
This benefit can not be overstated. Hedging refers to the purchase of one security that is likely to gain as an existing investment experiences a loss. For example, a portfolio of stocks are likely to experience losses in a stock market sell-off while an inverse ETF is designed to gain from such an event. Inverse ETFs are designed to move opposite, or inversely, to an underlying benchmark or index, whether that’s a stock, bond or commodity index. Adding another tool for an investor, inverse ETFs offer the ability to profit in bear markets, not just bull markets.
It’s easier than ever to tailor the hedges to a particular asset class (i.e. equities, bonds, currencies) and even sector within that class (i.e. financial stocks, high yield bonds, the euro, etc.). You can put on a full hedge with an inverse index ETF and essentially eliminate market risk or execute a partial hedge which will provide some downside protection but allow upside potential as well. We discuss several inverse ETF hedging ideas and compare them with other hedging strategies.
Lastly, there are inverse ETF benefits for an IRA, which can be a valuable way to protect retirement assets where hedging options are limited. Different retirement accounts (401(k)s, 403 (b)s, traditional IRAs, Roth IRAs, self-directed IRAs, etc) have different rules of what types of investments are allowed, depending on the broker. We aim to provide retirement protection ideas and updates using inverse ETFs throughout this site.
Defined Risk of Inverse ETFs
With inverse ETFs, your risk is defined because the most money you can lose is your cost of the ETF, just like if you bought a regular stock. While this might not seem like much of a benefit, other bearish strategies can involve unlimited loss, notably shorting stocks and certain types of options strategies.
Inverse ETFs add Real Diversification
Many investors are not as diversified as they believe. They collect a group of stocks or ETFs from different sectors and believe they are diversified. But all of these investments are “long” in nature. Studies have shown that during financial crises, most asset classes move together, minimizing the diversification benefits just when you need them the most. Adding an inverse ETF can add protection to your portfolio against a bear market in stocks by mitigating “market risk”. Or it can be used to tailor the hedge against a specific sector you feel may be overvalued (such as biotech stocks) or an overvalued asset class (junk bonds).
Low Cost of Inverse ETFs
Inverse ETFs are cost-effective ways to express a bearish opinion. They typically have low expense ratios of under 1%, most between 75 and 95 basis points. Some brokers even offer commission-free trading for some alternative or hedged ETFs (although the commission-free trading benefit is more prevalent for the larger, traditional ETFs). As their popularity increases, there may be commission-free trading for inverse ETFs, at least for the largest ones in terms of assets and trading volume.
Tax Benefits Using Inverse ETFs
Using an inverse ETF instead of selling a security (that may have accrued large capital gains) can defer the tax liability. This strategy works best of the stock you own is a large component of a sector ETF or index. For example, let’s say an investor has a large position in either Apple or Google (which is likely since they are the top two most widely held stocks) which also has large capital gains. Instead of selling the position, you could buy an inverse ETF on the NASDAQ 100, such as PSQ, of which Apple and Google together make up over 20%. If these stocks go lower, the NASDAQ 100 is likely to follow.
Compounding Potential of Inverse ETFs
While ‘compounding’ is generally thought of as the main risk of inverse ETFs in volatile or choppy markets, if the movement in the benchmark index trends strongly and persistently enough in the right direction, an inverse ETF can actually return more than the targeted return. This pertains to leveraged inverse ETFs, also. Granted, this benefit requires great timing as much as any other factor, so it shouldn’t be counted upon.
Here are a couple examples of when this has happened. In August of 2015, where the inverse ETF, SPXU, a triple leveraged inverse ETF, actually moved -3.4x the S&P 500 over the three-day period August 20-August 22 (you may have guessed it might be a -3x return). In fact, if you just took the intraday low during that flash crash on August 22nd (occurring in the first 15 minutes) the SPXU actually moved at a -4.2x. This shows how the power of compounding can work in your favor in a market moving persistently in one direction.
An example of this also occurred over a longer-term time period with leveraged ETFs. Take the 3x leveraged exchange traded fund tracking the small cap stock index, the Russell 2000. Note, this is not an inverse ETF, but a traditional (long) ETF. The bullish move in the Russell 2000 small cap index from the low in March of 2009 to the peak in 2015 was so persistent that the small cap exchange traded fund, TNA, went up almost 20x when you might have thought it would have gone up 11x (3.7x return for the index times 3= 11x). Another example where a strongly trending market can have compounding work in a leveraged ETFs favor.
Liquidity of Inverse ETFs
There is good liquidity for many inverse ETFs. Many can be easily traded through heavy volume and relatively narrow bid-ask spreads. They are also typically traded on major exchanges. Inverse ETFs that have low liquidity usually get shut down by the issuer and the money returned to fund investors.