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What Are Inverse ETFs?

An inverse ETF is a type of Exchange Traded Fund (ETF) that gains from a drop in the value of an underlying benchmark. Similar to leveraged ETFs, inverse ETFs also deal in financial derivatives. Inverse ETFs are comparable to short positions. This means selling securities with anticipation to buy at a lower price in the future. Inverse ETFs are also known as ‘Bear ETFs’ or ‘Short ETFs’.

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Inverse ETFs enjoy profits during a bear market scenario by using the financial strategy if short selling. Thus the primary goal of an inverse ETF is to generate gains for investors who believe that the price of the underlying benchmark is decreasing and will continue to decline in the near future.

How Do Inverse ETFs Work?

Inverse ETFs gain (or lose value) when the price of the underlying index falls (or rises). Thus, inverse ETFs have an inverse relationship with the index that it is tracking. For example, an inverse ETF tracks Nifty 50, and when the value of Nifty 50 falls, the inverse ETF gains. Therefore, the inverse exchange-traded fund is supposed to increase in value as the index loses its value.

Inverse exchange-traded funds aim to generate returns on a daily basis. Thus these ETFs deal in daily futures. The fund manager buys a futures contract and bets on the market falling. When the index falls by 2%, the inverse exchange-traded fund increases by 2%. The fund manager may use leveraging strategies and tools, such as short selling or purchasing and selling futures contracts, to achieve this inverse return.

Investors should not, unlike traditional ETFs, hold inverse ETFs for the long term. These ETFs are more like an intraday transaction than a long-term investment because the fund manager buys and sells them daily. As a result, there is no guarantee that the inverse exchange-traded funds will reflect the underlying index’s performance (in any direction).

Who Should Invest in Inverse ETFs?

Contrarian traders use inverse exchange-traded funds to benefit from the declining value of the benchmark index. These ETFs are high-risk investment schemes, thus, suitable for seasoned investors. Though the investments can generate significant returns, inverse ETFs do not suit all investors.

Since inverse exchange-traded funds deal in short selling as part of their strategy, the losses could be limitless. As a result, day traders and other short-term investors benefit the most from inverse ETFs.

Furthermore, investors with a long term investment horizon should not invest in these ETFs. Since they deal in daily trades, they are good short term investments. Thus if you have a short term investment horizon, are well versed with the market dynamics, and have high-risk tolerance levels can invest in inverse exchange-traded funds.

Things to Consider as an Investor

Following are the things to consider while investing in inverse exchange-traded funds:

Investment Horizon

Inverse exchange-traded funds are suitable for investors who have a short-term investment horizon. Since they take day positions, the returns may fluctuate in the long term. Thus, a short term investment tenure is necessary while investing in inverse ETFs.  

Investment Objective

Understand the investment objective of inverse exchange-traded funds before investing in them. An inverse ETF can track a sector, theme or broad market index. Thus, depending on the suitability of these ETFs to your investment goals, pick the right scheme.

Past Performance

Past performance doesn’t guarantee future returns. Furthermore, trading in derivatives is risky. However, by analysing the ETF’s historical performance, you will be able to understand how successful the fund manager was in predicting the market movements.  

Risk

Inverse exchange-traded funds are high-risk investment options since they are speculative in nature. These ETFs take daily derivative positions. Sometimes the derivative bets can be in favour, while sometimes, they can trigger high losses. As a result, these ETFs can lose most or all of its value. Therefore, it is important to consider the risks involved with investing in inverse exchange-traded funds before investing in them.

Expense Ratio

Inverse ETFs have a higher expense ratio than traditional ETFs. Since inverse exchange-traded funds trade in financial derivatives, the expense ratio is higher. Furthermore, inverse exchange-traded funds are actively managed, and it requires extensive research and technical expertise to manage the fund. As a result, the fund manager charges higher fees.

Advantages of Inverse Exchange Traded Funds

Following are the advantages of investing in inverse ETF funds:

  • Higher Returns: These ETFs have the potential to generate high returns when the market moves as predicted. In other words, inverse exchange-traded funds gain when the benchmark index loses its value.  
  • Alternative to Derivatives: Inverse exchange-traded funds provide indirect access to financial derivatives such as options and futures contracts. Dealing in derivatives is not easy, and it’s not everyone’s ball game. The trades can be inaccessible as well as expensive. Thus, through these ETFs, investors can take advantage of derivatives trading.
  • Hedging: Investors can diversify within an asset class while also hedging against losses with these ETFs. For example, if you have an ETF that tracks the NIFTY 50 benchmark, you can invest in an inverse exchange-traded fund. If the NIFTY 50 declines in value, you can cover your losses.

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