If news about market downturns and an imminent recession is making your head spin, you may be wondering how to hedge your portfolio against losses. One option may be an inverse ETF.
An inverse ETF aims to earn gains when an underlying stock market index goes down. So if the S&P 500 falls by 3% tomorrow, an inverse ETF tied to the S&P 500 should increase by 3% in value. Some inverse ETFs are leveraged and have numbers in their names such as "2X" or "3X." This means these inverse ETFs are designed to multiply the performance of a given index. So if the S&P 500 dropped by 3%, an inverse "3X" ETF would earn a 9% gain.
Inverse ETFs are considered to be volatile financial instruments better suited for experienced investors who are willing to monitor the performance closely and trade daily. Still, 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 futures contracts to benefit from the decline of a stock market index or a particular industry, such as energy or tech.
Futures contracts give you the right to buy or sell a certain security or asset at a set price and time. Inverse ETF managers use these futures contracts daily. They're essentially betting on the decline of the underlying security in order to profit.
For instance, an inverse ETF fund manager may hold swaps of futures contracts with different banks. If the index tied to the contract goes up, the fund must use its cash holdings to pay the return to the banks and thereby lose value. But if the index goes down, the banks end up paying the fund and increasing its value.
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Investing in inverse ETFs is often compared to short-selling. This strategy involves using a margin account to borrow shares of an asset to sell for a profit. But if you're shorting the asset, you're betting that its price will then drop. The idea is to buy the stocks back at a lower price to return to the broker and then pocket the difference.
Inverse ETFs, however, have a particular advantage. In both cases, you're betting on the decline of a particular asset. But with shorting, your potential for loss is essentially infinite, because a stock's price can go up indefinitely. So if your price movement predictions were really off, you'd need to buy those stocks back at inflated prices to return to your broker. But the lowest price an inverse ETF share can sink to is $0.
What are the risks of inverse ETFs?
One of the biggest drawbacks of an inverse ETF can be its fees. The average expense ratio for index equity ETFs was just 0.16% in 2021. But the average expense ratio for inverse ETFs is 1.06%.
Part of those high fees can be attributed to the fact that inverse ETFs are actively managed. Fund managers buy and sell expensive derivatives like futures contracts on a daily basis. This means more costs on their end and higher fees on yours.
So even if you correctly predict that an underlying index drops 3% in one day, the gain earned by your inverse ETF can be significantly diminished by a 1.06% expense ratio.
Should you invest in inverse ETFs?
Before you decide whether you want to jump into inverse ETFs, also called bear ETFs, let's review some pros and cons.
Pros
- Access: You can easily buy inverse ETF shares through an online broker just as you would buy an index ETF or stock.
- Risk adjustment: Unlike with shorting, you don't need a margin account, and you won't need to sell back stock shares at inflated prices if your predictions were wrong.
- Hedge potential: If your predictions come true, you can offset losses from an underlying index.
Cons
- High fees: While you can find standard index-based ETFs with expense ratios as low as 0.03%, the fees for inverse ETFs can go higher than 1%.
- Volatility: Share prices for inverse ETFs can swing sharply on a regular basis.
- Dedication: Because inverse ETFs can be highly volatile, you need to follow their price movements carefully and decide when to sell.
Timing is important in more ways than one. Because of their inherent volatility, inverse ETFs are meant to be held for relatively short periods -- like a day instead of years. So you shouldn't look at these as long-term investments. Think of inverse ETFs as short-term hedges against downturns in your holdings.
If you pursue inverse ETFs, remember it's just one component of a well-diversified portfolio and investing strategy that can help you capture returns under any market dynamics.
