As the stock market continues to rise, seemingly running ahead of fundamentals, more and more investors are becoming concerned that the stocks are becoming overvalued, and that a downward correction may be just around the corner. While safe haven investments such as the U.S. dollar and gold are popular picks for investors looking to profit from a decline in asset prices, the inverse correlation between these investments and equities is far from perfect.
A growing number of investors utilize inverse ETFs to accomplish a wide range of investment goals, ranging from establishing hedges in their portfolios to speculating on a pullback in prices. If used correctly, these products can be very powerful, but they can be complex and come with a number of risks that should be carefully considered. [For more ETF analysis, make sure to sign up for our free ETF newsletter or try a free seven day trial to ETFdb Pro].
Taking a short position in certain asset classes is, of course, noting new. Investors have been utilizing short selling for years, and those who have recognized asset bubbles in advance have made some nice profits doing so. But the rise of the ETF industry has brought this strategy within reach of a growing number of investors, and facilitated the shorting of an entire index instead of simply individual stocks.
Let’s be very clear: in the long run, shorting the stock market is not a sound strategy. But in the short to medium term, the ability to quickly establish a short position in various asset classes may be a very valuable tool. If your time horizon spans decades, rather than hours or weeks, you probably won’t want to include inverse ETFs in your portfolio. Inverse ETFs however are a very useful and efficient way for day traders and institutional investors to meet short term objectives. You can use an inverse ETF to short an index without having a margin account or other permission by a broker. Once again, ETFs aren’t dramatically changing the fundamental trading and investing strategies; they’re just an efficient vehicle for meeting already-existing goals [see Actionable ETF Trading Ideas].
How an Inverse ETF Works
The first thing you should understand about an inverse ETF is what these ETFs actually own, since they aren’t “long” on any of the traditional asset classes. Inverse ETFs own various derivatives, such as options, as a way to bet against the performance of any type of index (stock, currency, commodity, etc.) If the index achieves a positive return, the short position has a negative return, and vice versa. The performance of daily short ETFs consists of a number of factors, with the performance of the underlying benchmark being a critical factor (see this PDF document for more coverage of inverse ETF performance):
It is very important to note that most inverse ETFs seek to provide returns equal to 100% of the return on a benchmark index for a single day. While there is the potential for differentials in return to arise, short ETFs generally track the inverse performance of their benchmark very closely.
Advantages of Inverse ETFs
Inverse ETFs have a number of advantages over traditional short selling. First, short ETFs are available to a broad range of investors, and there are no margin requirements that restrict their use [see Free 7 Simple & Cheap All-ETF Portfolios].
Short selling is often perceived as a risky activity, and rightfully so. The loss potential for a short sale is unlimited, since the underlying asset price can theoretically appreciate indefinitely. While asset prices obviously won’t go to infinity, it isn’t uncommon for some to see triple digit gains over a relatively short period. The maximum loss profile in a short ETF is similar to that in a long position: the initial investment. If an investor takes a $100 position in SH and the S&P 500 jumps by 200%, the investor is only out the original $100 he invested in the first place.
There are of course some disadvantages to short ETFs as well: they are subject to “return drift” over time, and generally won’t track the inverse return on the relevant benchmark as closely as a traditional short position. ETFdb Pro members can get complete coverage of inverse equities ETFs in our ETFdb Category Reports (if you’re not a Pro member yet, you can sign up for a free trial of learn more here).
Popular Inverse ETFs
There are inverse ETFs covering just about every asset class, including equities, fixed income, commodities, and real estate. Inverse equities ETFs are the most popular among investors, and there are funds linked to many of the most popular domestic and international indexes, including:
- Short S&P 500 (SH)
- Short Russell 2000 (RWM)
- Short Dow 30 (DOG)
- Short QQQ (PSQ)
- Short MSCI Emerging Markets (EUM)
- Short MSCI EAFE (EFZ)
There are also inverse ETFs offering more targeted exposure to various sectors of the economy, as presented in the table below:
|Oil & Gas||DDG||Short Oil & Gas|
|China Equitites||YXI||Short FTSE/Xinhua China|
|Basic Materials||SBM||Short Basic Materials|
|Infrastructure||MLPS||Short Alerian MLP Infrastructure|
|Regional Banking||KRS||Short KBW Regional Banking|
Other Inverse ETFs
PowerShares and Deutsche Bank also offer a number of exchange-traded products that offer inverse exposure to commodities prices, including primarily oil and gas. A full list of these inverse commodity funds can be found here. ProShares also offers the Short 20+ Year Treasury (TBF), a fund that seeks to deliver returns that are the inverse of the Barclays Capital 20+ Year U.S. Treasury Index [see holdings of TBF here].
Uses of Inverse ETFs
Many assume that inverse ETFs are used primarily by speculators hoping to profit from a decline in asset prices. But in reality, there are a number of popular and effective uses for inverse funds, including:
- Volatility-Based Alternating Strategies: Some investors carefully watch the CBOE Volatility Index (better known as the VIX) and switch their exposure between long and short ETFs at certain volatility levels. For example, one may hold a long position in equity markets when the VIX is below 30 and switch to a short position when the “fear index” tops this point, a strategy that worked very well during the financial crisis in 2008 and 2009.
- Isolate Risk Factor Exposure: Inverse ETFs can be used in conjunction with other investments to isolate exposure to a particular economic factor. For example, investors looking to gain exposure to commodity prices may invest in the Market Vectors Hard Assets Producers ETF (HAP) and hedge out the equity exposure by also investing in the ProShares Short S&P 500 (SH) and Short MSCI EAFE (EFZ) [see charts of EFZ here].
- Bets on Relative Performance: Inverse ETFs can be used to establish “market neutral” portfolios that may profit if certain regions or sectors outperform others. An investor who isn’t sure of the direction of the markets, but believes that the technology sector will outperform financials could invest in both the Technology SPDR (XLK) and the ProShares Short Financials (SEF) [see technical analysis of SEF here].
Of course, inverse ETFs can be used to speculate as well, and generally do an excellent job of delivering profits in bear markets [see Free Report: How To Pick The Right ETF Every Time]
Further Reading on Inverse ETFs
If you’re interested in inverse ETFs, here’s some other good sources for information:
- Investopedia: Inverse ETF
- ETF.about.com: Six Questions to Ask About Inverse ETFs
- Fool.com: Shorting the Market With Inverse ETFs
Disclosure: No positions at time of writing.
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