What are Inverse ETFs?

What Do You Mean by Inverse ETFs?

Inverse ETFs are ETFs which take advantage of the decline in value of the benchmark. Unlike traditional ETFs, which track the performance of an index, an inverse ETF provides you with the opposite of what an index performs in a day.

Investors who focus on hedging against market downtrends or speculate about the decline of some sectors and indices.

As the name suggests, inverse ETFs make a profit when the performance of an index drops. For instance, in the case of the NIFTY 50 inverse ETF, investors can make a profit when the NIFTY 50 loses points.

However, the Securities and Exchange Board of India (SEBI) does not permit you to invest in these investment vehicles.

How Do Inverse Exchange Traded Funds Work?

Inverse ETFs depend on their derivatives to generate profits for their investors. Here is how an inverse ETF actually works:

1. To guarantee target exposure, these ETFs usually invest in daily futures and hold total return swaps or index futures as needed.
2. Throughout the day, the fund has positions that can produce an average of –1x the movement of the underlying index. The inverse ETF would gain 1% in response to a 1% drop in the underlying index and vice versa. Compounding causes these returns to fluctuate over several days.
3. Since they rely on daily traded futures contracts and other derivatives, they are essentially short-term investments.

Different Types of Inverse ETFs

Inverse ETFs can be divided into 3 types. They are:

• Sector-Specific Market

This type of inverse ETF offers exposure to multiple target areas in the market. Some of these sectors are energy, finance, technology, and many others.

• Broad Market

The broad market inverse ETFs track indices such as the NASDAQ 100 and S&P 500, which have inverse performance in the market.

• Leveraged Market

Leveraged inverse ETFs push to deliver multiples such as 2x or 3x of the inverse return on an index. However, they are very risky although they may provide better returns. They are also not recommended to hold for the long term.

What is the Right Time to Buy an Inverse ETF?

Investing in the inverse ETFs is not enough until you invest in them at the right time. If you think the market is trying to protect current portfolio holdings against future losses, you can purchase an inverse ETF. For instance, inverse ETFs can be an effective option for capital preservation in economically unstable situations due to geopolitical tensions. 

However, you must think about the daily reset in inverse ETFs, as this can be a huge time constraint. You can typically invest in these funds on a short-term basis by closely monitoring them.

If you think a particular industry is declining due to poor earnings or regulatory challenges, you can purchase an inverse ETF from that industry.

However, you should keep in mind that inverse ETFs are not appropriate for buy-and-hold investment strategies, and you should use them as part of a broader trading approach.

Inverse ETFs vs Short Selling: Key Differences

Once you have understood its meaning and types, you must then know the differences between inverse ETFs and short selling:

Benefits of inverse ETFs

• Accessibility

You do not have to worry about margin calls, interest costs, or short-selling limitations since you may trade these ETFs on the stock exchange just like you would any other ETF.

• Cost-Effectiveness

In comparison to hedge funds and individual stocks, inverse ETFs often have lower expense ratios and transaction costs.

• Diversification

By including assets that have a negative correlation with the market, these ETFs enable you to diversify your portfolio. Particularly during market downturns, this diversification can help lower overall portfolio risk and volatility.

• Flexibility

Inverse ETFs provide a range of solutions to suit your investing objectives and risk tolerance. Depending on how much you want to increase your possible gains or losses, you can choose between several levels of leverage, such as 1x, 2x, or 3x.

Limitations of Inverse ETFs

• Short-Term Focus

Inverse ETFs reset their exposure to the index every day and are intended for short-term trading. These ETFs may lose their intended correlation with the index if they are held for long periods of time.

• High Risk

If the market moves against your expectations, inverse ETFs might result in significant losses. Furthermore, due to rebalancing expenses, fees, liquidity issues, or market disruptions, inverse ETFs may encounter tracking mistakes, which might prevent them from precisely replicating the performance of the underlying index.

Final Thought

Inverse ETFs help investors hedge against market downtrends and gain from them. While they can protect your portfolio in any anticipated downward fluctuations, you must track them regularly. However, the SEBI has not permitted you to invest in inverse ETFs.

If you are interested in ETFs, download the PL Capital Group – Prabhudas Lilladher to invest. PL Capital allows you to invest in ETFs by offering you the opportunity to open a Demat account for free.

Frequently Asked Questions

• What is the best inverse exchange-traded fund?

Since the ‘best’ option depends on your unique market view, risk tolerance, and time horizon, there is not a single best ETF. Due to the impact of daily rebalancing and compounding, ETFs are complicated and short-term trading instruments that are not appropriate for long-term investing.

• What does a 3x inverse ETF mean?

A 3x inverse ETF is a specialised, high-risk fund intended for experienced traders to generate profit from or hedge against short-term market losses rather than long-term investment. Its goal is to generate three times the opposite daily return of a certain market index.

• How long should I stay invested in an inverse ETF?

Since inverse ETFs are intended for intraday or short-term trading rather than long-term investing, you should only hold them for a very short period of time. You should hold them usually for a few days or less, because daily rebalancing causes performance to drastically diverge from the inverse of the underlying index over time, posing a significant risk.

• Who purchases inverse ETFs?

Inventors and traders who anticipate a decline in the securities market and hedge portfolios against risks can invest in inverse ETFs.