What is an inverse ETF? (2024)

FAQs

How does an inverse ETF work? ›

An inverse ETF is a fund constructed by using various derivatives to profit from a decline in the value of an underlying benchmark. Inverse ETFs allow investors to make money when the market or the underlying index declines, but without having to sell anything short.

Compounding Risk

Since an inverse ETF has a single-day investment objective of providing investment results that are one times the inverse of its underlying index, the fund's performance likely differs from its investment objective for periods greater than one day.

Leveraged 3X Inverse/Short ETFs seek to provide three times the opposite return of an index for a single day. These funds can be invested in stocks, various market sectors, bonds or futures contracts.

Inverse ETFs have a one-day holding period. If an investor wants to hold the inverse ETF for longer than one day, the inverse ETF must undergo an almost daily operation called rebalancing. Inverse ETFs can be used to hedge a portfolio against market declines.

Over the long-term, inverse ETFs with high levels of leverage, i.e., the funds that deliver three times the opposite returns, tend to converge to zero (Carver 2009 ).

An inverse ETF is intended for intraday trading. The more frequently you trade intraday, the more transaction costs you incur. Owning an inverse ETF can result in losses if the ETF's target index rises in value — the sharper the increase, the greater the loss will be.

Commissions and Expenses

Every time you buy or sell a stock, you might pay a commission. This is also the case when it comes to buying and selling ETFs. Depending on how often you trade an ETF, trading fees can quickly add up and reduce your investment's performance.

Contrarian investors use inverse ETFs to profit from the decline in value of a given index or asset class, such as an index.

Vanguard S&P 500 ETF (VOO 1.24%) iShares Core S&P 500 ETF (IVV 1.26%) Vanguard Total Stock Market ETF (VTI 1.19%) Schwab U.S. Broad Market ETF (SCHB 1.17%)

Does Dave Ramsey recommend ETF? ›

But to be clear, Ramsey's all in favor of using ETFs when used properly. For investors who can use ETFs as part of a long-term, buy-and-hold investment program, rather than as trading vehicles, Ramsey has nothing bad to say about them.

Since they maintain a fixed level of leverage, 3x ETFs eventually face complete collapse if the underlying index declines more than 33% on a single day. Even if none of these potential disasters occur, 3x ETFs have high fees that add up to significant losses in the long run.

A big disadvantage of inverse ETFs

Volatility loss describes the effect of volatility on total returns. An investor can be directionally accurate in their assessment that the underlying security will decline in value but still lose money by investing in an inverse ETF.

Because they rebalance daily, leveraged ETFs usually never lose all of their value. They can, however, fall toward zero over time. If a leveraged ETF approaches zero, its manager typically liquidates its assets and pays out all remaining holders in cash.

Here's why leveraged and inverse ETFs reset daily: Daily Rebalancing: Leveraged and inverse ETFs use financial derivatives that provide returns based on the daily performance of the underlying index. To maintain their desired leverage or inverse exposure, these ETFs must rebalance their positions daily.

Historically, SQQQ decays around 7-8% per month, though this would likely be around 4-5% per month during a flat market such as that experienced so far this year.

The U.S. Securities and Exchange Commission defines inverse ETFs as funds that seek to deliver a return that is the opposite of the daily performance of a specific index or benchmark tracked by the fund. Inverse ETFs can track broad-market indexes, specific sectors or other types of benchmarks.

Hedging with Single Inverse ETFs appears feasible over medium investment horizons besides daily or very short term horizons. A tactical exposure to Single Inverse ETFs with entries and exits erodes lesser value than Buy & Hold.