Inverse ETFs: What They Are and How to Invest In Them

With markets jumping up and down, investors may seek to capture the inverse of market returns when share prices tank.

In short, it may be tempting today to try your hand at timing the market with an inverse exchange-traded fund.

On the surface, inverse ETFs appear to deliver the opposite returns of an underlying index’s investment performance. Yet this is not the case, as returns are in fact more nuanced.

Before diving in, investors should grasp what inverse ETFs are and how they work.

[See: 10 Best-Performing ETFs of 2020.]

If you believe that you can predict when the market will fall with any degree of precision, then investing in inverse ETFs might be right for you — but first, understand what’s behind the curtain. Here are some things to keep in mind:

— What is an inverse ETF?

— How do inverse ETFs work?

— How and why to invest in inverse ETFs.

— Bottom line: rules to follow.

What Is an Inverse ETF?

Also known as a short or bear ETF, an inverse ETF is created using derivative contracts such as futures to profit from the reverse of an index’s price movements. A futures contract is an agreement to buy or sell an asset at a specific time and price.

Inverse ETFs are frequently compared with shorting securities or indexes. Both investment strategies are ways to potentially profit from a market decline. Investors who short an asset borrow the investment today and sell to traders with the intent of buying the asset back at a later date and at a lower price.

If markets decline as predicted, the investor will make a profit from the difference between the sell price and buy price, after expenses. If markets rise, the investor must buy the stock back at a higher price, thus losing money.

Unlike shorting, inverse ETFs attempt to avoid the cost of borrowing securities through a margin account, which requires interest payments and fees to a broker.

In the case of inverse ETFs and shorting assets, if the investment price increases instead of decreasing, the investor will lose.

Kelly Crane, president and chief investment officer at Napa Valley Wealth, recommends a cautious approach when investing in these risky assets. “We employ inverse ETFs as a piece of a short-term strategy, but they can be dangerous for the average investor,” Crane says. “Because most are repriced daily, holding them for even a day too long can significantly impact returns.”

How Do Inverse ETFs Work?

There are two types of inverse ETFs.

The first type is a fund designed to track the inverse performance of a given index, such as the ProShares Short S&P500 ETF ( SH), says Steven Jon Kaplan, CEO of True Contrarian in New Jersey. This fund seeks daily investment results that approximate the inverse of the performance of the S&P 500.

The risk with a fund such as SH comes from the daily compounding of each day’s returns. So holding periods of greater than one day can result in returns that significantly diverge from the target return.

“I would caution investors about what inverse ETFs are for and are not for,” says Linda Zhang, senior advisor at SoFi. “Inverse ETFs are meant to be used as a hedging tool to protect against a market correction and are not designed for a buy-and-hold strategy.”

In 2020, between Jan. 1 and July 31, the S&P 500 is essentially flat — while SH is down approximately 11%.

The second type of inverse ETFs is leveraged and created to return an increase in the inverse of an index’s performance, Kaplan says. These are riskier than the first variety and only appropriate for investors who are extremely confident in their forecasting ability and comfortable with a great amount of risk.

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For example, the Direxion Daily Small Cap Bear 3X ETF ( TZA) is designed to magnify three times the inverse of the Russell 2000’s daily performance. So if the Russell 2000 drops 2% tomorrow, this ETF should gain approximately 6%. In contrast, if the Russell 2000 increased in value by 5% in one day, TZA would decline 15%.

The daily compounding of levered inverse ETFs will quickly destroy capital when these funds move against you. Their volatility is a reminder that inverse ETFs are to be used strictly as short-term trading vehicles, says Daniel Lugasi, portfolio manager at VL Capital Management in Orlando, Florida.

How and Why to Invest in Inverse ETFs

In this case, the “how” is simple: Buy an inverse ETF in your brokerage account.

As options go, the ProShares Short S&P 500 ETF is the largest, with $3.08 billion in assets. And last year, a top-performing inverse ETF was the ProShares UltraShort Bloomberg Natural Gas ETF ( KOLD) with a return of nearly 80%.

Another sector pick, the MicroSectors FANG+ Index Inverse ETN ( GNAF) is a way to trade on the short-term movements of the popular FAANG stocks — Facebook ( FB), Apple ( AAPL), ( AMZN), Netflix ( NFLX) and Alphabet ( GOOG, GOOGL).

The “why” of investing in inverse ETFs is another story.

Although Rob Isbitts, founder and chief investment strategist at Sungarden Investment Research in Fort Lauderdale, Florida, has been investing in them for a while, he cautions investors to have a well-thought-out, disciplined approach to how they will use inverse ETFs.

Isbitts says they can be powerful or destructive and that inverse ETFs are not all the same.

The reason to invest in an inverse ETF is to profit from a down movement in the market. Typically, when the stock market falls, most investors lose money. If an individual calls the market direction appropriately, profits can be made by investing in inverse ETFs.

Successful inverse ETF investors understand how the investment works and that it is a short-term trading vehicle — not a buy-and-hold investment.

According to Isbitts, the levered ETFs are poisonous to your wealth due to the market’s inherent volatility.

Bottom Line: Rules to Follow

Before you invest in inverse ETFs, make sure that you have the temperament and knowledge to trade these risky investments.

An inverse ETF isn’t a “set it and forget it” type of investment. It requires close monitoring.

[Read: Does Market Volatility Mean It’s Time to Rebalance Your Portfolio?]

When investing in an inverse ETF, you could experience both gains and losses mounting up rapidly, so pay careful attention to their returns.

Ultimately, before deploying your resources into an inverse ETF, understand the potential loss if you incorrectly predict the market’s direction. Again, these investments are most appropriate for advanced investors who are able to handle risk.

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