When news of a market downturn and an impending recession is spinning your head, you may be wondering how to protect your portfolio from losses. One option could be an inverse ETF.
The goal of an inverse ETF is to make a profit when an underlying stock market index falls. So if S&P500 Tomorrow it falls 3%, an inverse ETF linked to the S&P 500 should gain 3%. Some inverse ETFs are leveraged and have numbers like “2X” or “3X” in their names. This means that these inverse ETFs are designed to multiply the performance of a specific index. So if the S&P 500 fell 3%, an inverse “3X” ETF would return a 9% gain.
Inverse ETFs are considered volatile financial instruments better suited for experienced investors who are willing to closely monitor performance and trade daily. Nevertheless, inverse ETFs can play a role in a well-diversified portfolio and investment strategy.
What is an inverse ETF?
An inverse ETF is a type of exchange-traded fund that uses derivatives, such as stock indices or futures, to profit from the decline of a specific industry, such as energy or technology.
Futures contracts give you the right to buy or sell a specific security or asset at a specific price and time. Inverse ETF managers use these futures contracts on a daily basis. You are essentially betting on the underside of the underlying security to profit.
For example, an inverse ETF fund manager can exchange futures contracts with different banks. If the index linked to the contract rises, the fund must use its cash holdings to pay returns to banks, reducing its value. But when the index falls, the banks pay out the fund and increase its value.
Investing in inverse ETFs is often compared to short selling. This strategy involves using a margin account to borrow shares of an asset in order to sell it for a profit. But if you short the asset, you’re betting that its price will fall. The idea is to buy back the shares at a lower price to return to the broker and then pocket the difference.
However, inverse ETFs have a particular advantage. In both cases, you are betting on the expiry of a specific asset. But when you go short, your potential for loss is basically infinite because the stock price can go up indefinitely. So if your price action predictions were indeed wrong, you would have to go back to your broker to buy back those shares at inflated prices. But the lowest price an inverse ETF stock can go down is $0.
What are the risks of inverse ETFs?
One of the biggest downsides to inverse ETFs can be their fees. The average expense ratio for index stock ETFs was just 0.16% in 2021. However, the average expense ratio for inverse ETFs is 1.06%.
Part of these high fees are due to the fact that inverse ETFs are actively managed. Fund managers buy and sell expensive derivatives such as futures contracts on a daily basis. This means higher costs on their end and higher fees for you.
So even if you correctly predict an underlying index to fall 3% in one day, your inverse ETF’s profit could be well below the 1.06% expense ratio.
Should you invest in inverse ETFs?
Before you decide whether to get into inverse ETFs, also known as bear ETFs, let’s go through some of the pros and cons.
- Access: You can easily buy inverse ETF shares through an online broker, just like you would buy an index ETF or a stock.
- Risk adjustment: Unlike short selling, you don’t need a margin account, and you don’t have to sell back stock at inflated prices when your predictions were wrong.
- Rescue Ability: If your predictions come true, you can offset losses from an underlying index.
- High fees: While you can find standard index-based ETFs with expense ratios as low as 0.03%, inverse ETFs can have fees as high as 1%.
- Volatility: Stock prices for inverse ETFs can fluctuate rapidly on a regular basis.
- Loyalty: Because inverse ETFs can be very volatile, you need to carefully monitor their price movements and decide when to sell.
Timing is important in more ways than one. Due to their inherent volatility, inverse ETFs are held for relatively short periods of time – e.g. B. a day and not years. Therefore, you should not consider these as a long-term investment. Think of inverse ETFs as short-term hedges against a fall in your holdings.
If you’re following inverse ETFs, remember that this is just one component of a well-diversified portfolio and an investment strategy that can help you generate returns amid any market dynamics.