What are Inverse ETFs?
When you enter the financial market, there are always only two directions your investments can go: Upwards or Downwards. An upwards trend or uptrend is when the prices of the securities are constantly rising, and investors expect them to rise even further. A downwards trend, or downtrend, is when the prices of the securities are constantly falling, and it is expected that they will fall even further. Beginner investors who are not fully experienced with the technicality of the financial market start with equities and have only one hope for the market, always to show an uptrend. However, the financial market does not work on hopes but on the demand and supply forces that establish the prices.
The first thing experienced investors do to mitigate their risk is to diversify. There are numerous other investment instruments apart from equities, such as derivatives, mutual funds, ETF etc., that makes diversification possible. However, if you choose ETFs to invest for diversification, what happens if the market starts showing a downtrend? Wouldn’t diversification fail if your investments fall in their value?
Professional investors choose diversification within the asset class to avoid such situations. They divide their capital according to their risk appetite and invest in two different sets of instruments within the same asset class. One of the most widely used examples of such investment is Inverse ETFs. In this blog, you will understand Inverse ETFs' meaning and how they allow investors to make profits even when the market is showing a downtrend.
To start, here are some terms you will need to understand before you move on to learn about Inverse ETFs.
What are Derivatives?
Derivative investors trade using two contracts called Futures and Options.
Futures Contract: A futures contract is an agreement between the buyer and the seller of a particular asset. The buyers purchase a specific quantity of the asset at a predetermined price payable at a specific time in the future. This contract remains until maturity, and investors can sell them if the price has risen at the time of the expiry to make a profit.
Options Contract: An options trading contract is generally permitted in top assets wherein the trader has the right but not a legal obligation to buy/sell the purchased security at a fixed price. Such a contract helps investors make a profit based on price fluctuations without buying/selling the contract.
What are ETFs?
Exchange-traded funds are types of Mutual Funds that aim to track the performance of a specific index such as NIFTY 50, NIFTY Next 50, NIFTY Bank, etc. An index is a basket of stocks representing certain segments of markets. Exchange-traded funds invest in the same stocks as those in the index and the same proportion as their weight in the index. Hence, they can mirror the performance of the underlying index. These exchange-traded funds can be based on indices tracking various asset classes like equity shares (e.g. NIFTY 50 ETF), bonds (e.g. 10-year G-Sec ETF), Gold (e.g. Gold ETF), Tri-party Repo (e.g. Liquid ETF), and derivatives such as futures and options.
What are Inverse ETFs?
Inverse ETFs are a class with an Exchange Traded Fund that is created by using derivatives contracts as the base. Inverse ETFs are designed in a way where investors make profits if the underlying benchmark is declining in value. You can think of Inverse ETFs as the process of shorting, where you borrow securities, sell them immediately and then buy them again when their price falls, thereby making a profit based on the price difference.
An Inverse ETF is also called “Bear ETF” or “Short ETF” as it profits from a bear market while using the financial process of shorting securities. The main aim of Inverse ETFs is to provide profit opportunities to the investors if they think that the price of the underlying benchmark is falling and will fall further soon.
For example, if the ETF is mirroring the NIFTY 50 benchmark, and you think that the price of the benchmark will fall, you can invest in an Inverse ETF with the same underlying benchmark. Once the price starts falling, you will start making profits.
How do Inverse ETFs work?
A majority of Inverse ETFs use derivatives, specifically a futures contract to bet against the market rising higher. The only way you can make profits in Inverse ETFs is when the prices start falling. An Inverse ETF mirroring the underlying assets of the benchmark rises in price by the same percentage with which the market has fallen. Once you minus the fee and commission, you are left with the net profits.
Unlike traditional ETFs, Inverse ETFs are not held by investors for the long term. As the fund manager buys and sells the Inverse ETFs daily, they are more like an intraday trade than a long term investment. Hence, it is not a guarantee that the Inverse ETFs will match the future performance of the underlying direction (in any direction).
However, as the value of Inverse ETFs is calculated every day, they can end up complicating the rebalancing process. Furthermore, as they are traded in high volume and, frequently, they come with high fund expenses and carry an expense ratio of more than 1%.
Benefits of Inverse ETFs
Here are the benefits of Inverse ETFs:
- Diversification: Inverse ETFs allow investors to diversify within the asset class and hedge against the losses. For example, if you have invested in an ETF that tracks the NIFTY 50 benchmark, you can invest in an Inverse ETF. You can square off your losses in case NIFTY 50 falls in price.
- Margin Account: One of the best advantages of Inverse ETFs is that they don’t need a margin account to be held by the investor. You can purchase Inverse ETFs by only having a brokerage account.
- Limited Risk: Unlike shorting stocks, where you are exposed to unlimited losses, Inverse ETFs come with limited risk. The risk in the case of Inverse ETFs is only limited to the individual unit of the ETFs, just like an individual stock.
- Low Expense Ratio: Almost all Inverse ETFs have an expense ratio lower than 2%. This makes Inverse ETFs a cost-effective investment instrument when compared to short selling and other bearish strategies available in the market.
- Numerous Options: Investors can choose from a host of Inverse ETFs that track almost all the major market benchmarks. You can browse and choose Inverse ETFs that suit you best according to your investment strategy.
Inverse ETFs provide a low-risk profit-making opportunity to investors who want to ensure they are profitable in a bearish market. Furthermore, it makes up for an effective investment instrument for investors who just want to hedge against their bullish investments for the time when the prices of their bullish securities fall. However, Inverse ETFs are not permitted in India. The only option available to such investors is to short stock futures and index futures which can be highly risky and come with substantial risk.
Frequently Asked Questions Expand All
Inverse ETFs are also known as “Short ETFs” and “Bear ETFs”.
Yes, Inverse ETFs are one of the best instruments to hedge against the market. It is because Inverse ETFs rise in value by the same percentage with which the market falls.
Generally, investors sell Inverse ETFs within one day. However, they can hold it for long but have to rebalance and actively manage them for any compounding risk.
If you are thinking of holding inverse ETFs overnight, you will have to manage and rebalance them every day until you sell them.