An inverse ETF is an exchange-traded fund (ETF) made up of different derivatives used to make money when the value of an underlying standard goes down. Putting money into inverse ETFs is a lot like taking out a bunch of short positions, which means borrowing stocks and selling them to repurchase them at a lower price.

This kind of ETF is called a “Short ETF” or “Bear ETF.”

How to Understand Inverse ETFs

A lot of negative ETFs get their money from daily futures contracts. It is agreed upon that an asset or property will be bought or sold at a particular time and price. Traders can bet on the direction of the price of a security with futures.

Because inverse ETFs use derivatives, such as futures contracts, buyers can bet the market will go down. If the market drops, the inverse ETF increases by about the same amount minus the broker’s fees.1

They are not long-term investments because the fund manager buys and sells derivative contracts daily. Because of this, we can’t be sure that the inverse ETF will have the same long-term success as the index or stocks it follows. Fund costs often increase when you trade a lot; some negative ETFs can cost 1% or more.

Pros

• Investors can make money with inverse ETFs when the market or the measure they are based on decreases.
• Investors can protect their portfolios with inverse ETFs.
• For many prominent market indices, there is more than one inverse ETF.

Cons

• If investors bet wrong on the way of the market, inverse ETFs can cause them to lose money quickly.
• You could lose money if you hold on to inverse ETFs for more than one day.
• When compared to regular ETFs, negative ETFs have higher fees.
• Short Selling vs. Backwards ETFs

One good thing about inverse ETFs is that buyers don’t need a margin account to buy them, which is necessary for short positions. For traders who have a margin account, a broker will give them money so they can trade. An advanced trade strategy is used when shorting, and the margin is used.

When traders go into short positions, they borrow securities to sell to other traders. They don’t own the securities. The plan is to get the asset back at a lower price and end the trade by giving the margin loan the shares back. There is, however, a chance that the security’s value will go up instead of down. If this happens, the owner will have to repurchase the securities at a higher price than the original margined sale price.

Short selling needs a credit account and a stock loan fee to pay a broker for the shares needed to sell short. It may be hard to find shares to short in stocks with a lot of short interest, which increases the cost of short selling. When traders aren’t careful, they can quickly get in over their heads because the cost of borrowing shares too short can often be more than 3% of the amount borrowed.

Anyone with a brokerage account can buy inverse ETFs with cost ratios of less than 2%.2Investors can still take a position in an inverse ETF for less money and with less hassle than selling individual stocks short.

Different Kinds of Inverse ETFs

If you want to make money when extensive market indexes like the Russell 2000 or the Nasdaq 100 go down, you can use inverse ETFs. On the other hand, there are inverse ETFs that focus on specific industries, like energy, consumer goods, or finances.

Some investors use inverse ETFs to make money when the market goes down, while others use them to protect their investments from rising prices. For example, buyers who own an ETF that tracks the S&P 500 can protect themselves against drops in the S&P by also holding an ETF that tracks the S&P backward. That being said, hedging also comes with risks. If the S&P increases, investors may have to sell their inverse ETFs because they will lose money, which could cancel out any gains on their original S&P purchase.

Inverse ETFs are short-term trading tools that buyers must use at the right time to make money. If buyers put too much money into inverse ETFs or don’t time their entries and exit well, they could lose a lot of money.

You can double and triple reverse ETFs.

A leveraged ETF is a fund that uses derivatives and loans to make the returns of an index it tracks bigger. Most of the time, the price of an ETF goes up or down by the same amount as the index it tracks. A leveraged ETF is meant to make profits twice or three times as high as the index.

Leveraged inverse ETFs try to give a more significant return when the market is decreasing, which is the same idea behind leveraged goods. For example, if the S&P drops by 2% daily, an investor in a 2X-leveraged inverse ETF will get a 4% daily return minus fees.1

An example of an inverse ETF in the real world

ProShares Short S&P 500 (SH) gives you exposure to big and midsize companies in the S&P 500 in the opposite direction. Since the fourth quarter of 2023, it had a net worth of about $1.93 billion and a cost ratio of 0.88%.4The inverse ETF is meant to be a one-day trading bet and shouldn’t be kept for more than one day.

Stocks in SH went down 1.07% on November 2, 2023, when the S&P rose. They went from $14.88 to $14.72. If people had put their money into the SH on that market-up day, they would have lost money.5

How Do Short-Term ETFs Work?

To sell short in the underlying index, inverse ETFs use futures, swaps, and options contracts, among other alternatives. They are also rebalanced daily to keep the opposite relationship even though the markets change daily.

Why would traders buy ETFs that lose money?

Traders can use inverse ETFs to profit from or protect themselves from market drops. Short-term players may also use them to bet on moves that go down.

Why are inverse ETFs only meant to be held for a short time?

Because they are rebalanced daily, inverse ETFs’ long-term performance often deviates from their actual inverse performance. They also make losses bigger when markets are volatile and going up. Negative ETFs tend to lose value over time; it doesn’t matter if the market they track goes up or down. Because of this, inverse ETFs are complicated goods that should not be used as long-term investments that you hold on to.

Conclusion

• An inverse ETF is a fund that uses different swaps to make money when the value of an underlying benchmark goes down.
• Investors can make money with inverse ETFs when the market or the index they track goes down, but they don’t have to sell anything short.
• There are usually more fees to run inverse ETFs than regular ETFs.
• Inverse ETFs are only meant to be held for a short time.