When investing in the stock market, some investors may think the only way to profit is from the markets going up. However, that is not the case; there also is a way for investors to profit when the markets decline. For individual stocks and ETFs, an investor can take a short position – in which a stock is borrowed and sold, and the investor hopes to buy back the stock at a lower price.
As it pertains to exchange-traded funds, there is a convenient way to make money when the market falls without having to take a short position. This is through inverse ETFs, which gain in value when the market or underlying sector in question falls in value. Several inverse ETFs take positions against the entire market or a specific sector of the market.
Possible Downside Catalysts
The S&P 500 Index has delivered modest returns so far this year. The index is up approximately 1% year-to-date. But several potential headwinds face the stock market, which could cause stocks to decline the rest of the year. Just a few of these issues include the economic slowdown in the emerging markets, the strengthening U.S. dollar and the possibility that the markets are overvalued.
If corporate profits decline for an extended period, then stocks likely will decline. As a result, investors can profit from a market correction or an economic recession by investing in inverse ETFs.
What Investors Should Know About Inverse ETFs
Many investment firms offer investors a wide range of inverse ETFs. For example, the ProShares UltraPro Short S&P 500 ETF (SPXU ) seeks to return daily investment results that correspond to three times the inverse of the S&P 500’s daily performance. During 2015, the SPXU exchange-traded fund has not performed well, mainly because there has been a market rally since the August sell-off.
Since the stock market has rallied considerably over the past several years, this fund’s long-term performance has suffered. The SPXU declined in value by approximately 40% per year over the past five years as the stock market enjoyed a massive rally since the recession of 2008 and 2009. However, if the economy goes into recession and the markets decline, expect the SPXU to outperform the market.
Some inverse ETFs track the performance of a specific sector of the stock market. For example, the Direxion Daily Energy Bear 3X ETF (ERY ) seeks daily investment results – before fees and expenses – of 300% of the inverse of the Energy Select Sector Index’s performance. This fund has performed quite well so far in 2015. Thanks to the huge collapse in energy prices and the resulting effect on the energy sector, the ERY fund is up 12% since the beginning of 2015 – and it was up by nearly 100% during the August sell-off.
Bottom Line
As a result, inverse ETFs can be a great opportunity for investors to profit from market declines. However, they are risky because they employ leverage to produce returns. If the market continues to increase, leveraged inverse ETFs can lose a significant amount of value. Investors should consider the risks and opportunities involved before buying an inverse ETF.
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