An inverse exchange traded fund (inverse ETF) is a fund that trades like a traditional stock on an exchange, but yields a return that is inversely proportional to a given index. For example, the Short Standard & Poor's 500® (S&P 500®), which is the inverse ETF of the S&P 500®, will generate about a 12 percent return when the S&P 500® drops 12 percent. Similar to a short position on an individual stock, an inverse ETF allows an investor to establish a hedge or speculate on a bear market. Unlike taking a short position, however, the inverse ETF, also called a short ETF, does not require a margin account, allows a short position on an entire index, and limits the scope of an investor's potential loss to the amount of the original investment.
In addition to speculative gains, investors can use inverse ETFs for a variety of investment strategies. When combined with other assets, inverse ETFs can allow an investor to segregate risks of different parts of the market. For example, an investor can choose to hedge out a bear stock market by investing in the inverse ETF for the S&P 500®, while at the same time investing in a long ETF for commodities. Many investors will alternate between inverse ETFs and long ETFs based on the market volatility. When the Chicago Board Options Exchange (CBOE) Volatility Index is above 30, investors will invest in short ETFs, and conversely, when the CBOE Volatility Index dips below 30, they will hold long positions.
A unique feature of inverse ETFs is the use of derivatives. Derivatives are securities based on contracts between two or more parties, the value of which derives from the value of one or more underlying assets, such as stocks, commodities, interest rates, or currencies. The derivatives are traded using borrowed money, creating leverage and amplifying the potential gains and losses. Dramatic fluctuations in prices can lead to indefinite correlation of the ETF share price with the benchmark.
Compared to mutual funds, ETFs have relatively low annual fees. A reason for the low fee is the fact that ETFs are passively managed, with changes linked to changes in the index. Market timing is critical, and investors must stay on top of the decision of when to exit and enter certain markets. Investors have to pay a commission to the brokerage on the purchase and sale of ETF shares. The commission fees for the trading of ETF shares can substantially add to the cost of investment.