How Do Inverse ETFs Work?

An inverse ETF can turn a bad day for the markets into a good day for investors, but make sure you understand what you're doing first. Image Source: Pixabay

An inverse ETF, also known as a "short ETF" or "bear ETF," is an exchange-traded fund designed to return the exact opposite performance of a certain index or benchmark. Companies such as ProShares and Direxion offer a variety of inverse ETFs. Here are some things to consider before investing in one.

How inverse ETFs work

An Inverse ETF uses derivatives and other methods in order to produce a daily performance that is in the opposite direction of a certain index. Such funds can have a one-to-one correlation with the targeted index, or they can be leveraged. For example, the ProShares Short S&P 500 (NYSEMKT: SH) is designed to match the daily returns of the S&P 500 index, just in the opposite direction. On a day when the S&P 500 rises by 3%, this ETF should fall by the same percentage.

On the other hand, some inverse ETFs are leveraged, and thus designed to magnify the inverse of an index's performance. The Direxion Daily Small Cap Bear 3X Shares (NYSEMKT: TZA), for instance, is designed to produce returns three times the inverse of the Russell 2000's daily performance. In other words, if the Russell 2000 drops by 2% tomorrow, this ETF should gain roughly 6%.

Notice that I used the phrase "daily performance." This is extremely important to understanding how inverse ETFs work. Inverse ETFs and leveraged ETFs rebalance their investment strategies on a daily basis in order to maintain a constant leverage ratio. We'll get into the specifics of how they do this shortly, but in a nutshell, this makes inverse ETFs more appropriate for short-term strategies rather than as long-term investments.

Drawbacks of inverse ETFs

There are a couple of downsides to inverse ETFs that you need to be aware of. First, since these are actively managed funds, they tend to have relatively high expense ratios -- typically in the ballpark of 1%. Now, if you hold an inverse ETF for a short period of time, this isn't necessarily a big deal, but it's worth mentioning if you're considering an inverse ETF as opposed to simply shorting stock.

Second, because of the daily rebalancing, inverse ETFs tend to underperform over long periods of time, as opposed to simply shorting a stock or index fund. This is best illustrated with an example.

Let's say that you think a hypothetical index is going to have an awful week, so you're deciding between shorting an index fund or buying an inverse ETF. On the first day of the week, the index starts at $1,000 and drops to $900, and on the second day, the index falls to $800, lower value. In this case, simply shorting an index fund would produce a 20% gain.

However, because each day's performance is a separate event with an inverse ETF, you'd gain 10% the first day, and another 11% the second day (the decline from $900 and $800), for a compounded gain of 21%. When prices are dropping, the inverse ETF produces good results.

But, what if the index rebounds? Let's say that on the third day, the index regains all of its losses. Thanks to the laws of mathematics, the index would need a 25% rebound to erase those losses – which would produce a 25% loss in the inverse ETF on that day. While a simple short-selling strategy would break even, an inverse ETF would be down by more than 12% over the three-day period.

As you might imagine, this effect is amplified even further with 2x and 3x leveraged inverse ETFs.

Should you use inverse ETFs?

Because of the daily rebalancing, inverse ETFs are best used for short-term market timing and hedging strategies, which are best left for professionals and highly experienced investors.

The point is that inverse ETFs are not the same thing as shorting an index for extended periods of time, and it's a mistake to treat them as such.

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