What Is an Inverse ETF?

Exchange-traded funds have opened up the investing universe to ordinary investors, making it possible to get access to markets and strategies that were previously unavailable. One innovation that ETFs brought to the investing community was the ability to bet against the market. Inverse ETFs are designed to rise when the market falls, offering an alternative to selling stocks short and avoiding some of the risk that short-selling entails. Inverse ETFs come in leveraged and unleveraged versions, and environments like the long bull market in stocks over the past eight years have done a lot of damage to inverse ETF investors. Nevertheless, inverse ETF investors hope that they'll be able to capture gains in future market corrections and use the funds to manage their overall portfolio risk.

Notable inverse ETFs

Data source: fund providers.

The way that inverse ETFs work

Inverse ETFs offer investors a chance to match the opposite of the return of an underlying index each day. For instance, if the S&P 500 falls 1%, then the way that the Short S&P 500 ETF is set up, its price should rise by 1%. The same concept applies to leveraged inverse ETFs, except that the returns are multiplied. For the UltraShort S&P 500 ETF, a 1% decline in the index should produce a 2% rise for the fund shares.

Inverse ETFs use different methods to produce these results. Most use derivatives such as swap contracts that produce the desired returns relative to the target index. The funds hold cash as collateral against those derivatives, and you can also often find futures contracts for inverse ETFs that track the most popular stock indexes.

Image source: Getty Images.

Risks and rewards of inverse ETFs

Inverse ETFs are particularly useful in a couple of situations. First, if you invest in an IRA or other retirement account, then you usually won't be allowed to take short positions in a stock or fund. That prevents you from using short-selling techniques to bet against the market. Retirement accounts are allowed to own inverse ETF shares, however, because the total loss is limited to the amount you pay for the shares, and there's no inherent use of margin capacity from the broker or financial institution overseeing the retirement account.

Also, if you want to make a short-term bet on the direction of the market, then inverse ETFs are well suited to trading. The daily nature of inverse ETF return calculations make them appropriate for short-term use, but over long periods of time, they aren't as effective.

The obvious risk of inverse ETFs is what happens when you're wrong about the direction of the market. As the inverse ETFs listed above show, a prolonged bull market can be devastating for inverse ETFs. Note that the indicated returns are annualized, with the worst-performing of those inverse ETFs losing almost half of their investors' money year in and year out. To their credit, the fund managers of inverse ETFs are very upfront about the potential for losses if their products are misused for long-term investment, but that doesn't stop some investors from using them that way anyway.

Do you need inverse ETFs?

Most ordinary investors won't have much need for inverse ETFs. Over time, stocks have generally followed an upward trajectory, and long-term investors will likely do better sticking to more positively oriented investments. As short-term hedges against market volatility, inverse ETFs have tactical uses for those who are overly concerned about risk. It's usually better to maintain a risk tolerance in your overall portfolio that allows you to weather ups and downs in the market without the use of hedges like inverse ETFs.