How inverse ETFs may help you gain in a bear market?

Key Takeaways

An inverse exchange-traded fund (ETF) uses a variety of derivatives to profit from a drop in the value of a benchmark index that serves as its underpinning.

The holding of various short positions, which entails borrowing assets and selling them in the hopes of repurchasing them at a reduced price, is comparable to investing in inverse ETFs.

Some of the most widely traded inverse ETFs include ProShares UltraPro Short QQQ (SQQQ), ProShares Short UltraShort S&P500 (SDS), Direxion Daily Semiconductor Bear 3x Shares (SOXS), and so on.

Understanding Inverse ETFs

Inverse ETFs typically use derivatives—like futures contracts—that allow investors to speculate that the market will decline.

Many inverse ETFs generate their returns using daily futures contracts. A futures contract is an agreement to purchase or sell securities or assets at a certain price and date. Investors can wager on the course of a security's price using futures.

If the market falls, the inverse ETF increases by about the same percentage, minus broker fees and commissions.

Since the fund manager buys and sells the derivative contracts every day, inverse ETFs are not long-term investments. As a result, it is impossible to predict whether the inverse ETF will outperform the index or the equities it is tracking over the long term.

Inverse ETFs typically have higher fees than conventional ETFs.

Inverse ETFs vs. Short Selling

A "Short ETF" or "Bear ETF" is another name for an inverse ETF.

Inverse ETFs have the advantage of not requiring the investor to maintain a margin account, which would be necessary if they wanted to open short positions. In a margin account, a broker loans money to a trader. Shorting is a sophisticated trading strategy that uses margin.

Investors who take on short positions do so to sell the securities to other traders; they do not own the stocks. The objective is to buy the asset back at a lower price and close the trade by giving the margin lender the shares.

A stock loan charge must be paid to a broker for borrowing the shares required for a short sale. High short interest in stock may make it difficult to find shares to be short, which raises the cost of short selling. The cost of borrowing shares to short can frequently be greater than 3% of the borrowed amount.

On the other hand, inverse ETFs frequently have expense ratios of around 2% and are accessible to everyone with a brokerage account. Despite the expense ratios, investing in an inverse ETF may be simpler and less expensive for a trader than shorting equities.

Leveraged Inverse ETFs

A leveraged ETF is a fund that boosts the returns of an underlying index using derivatives and debt. Usually, the price of an ETF changes in direct proportion to the index it follows. A leveraged ETF is made to increase returns by a factor of 2:1 or 3:1 over the index.

Similar to leveraged products, leveraged inverse ETFs are designed to increase returns during bear markets. A 2X-leveraged inverse ETF tracking the S&P 500 index, for instance, will offer the investor a 4% return after fees if the S&P 500 index has fallen by 2%.

Examples of Inverse ETFs

The following inverse ETFs are some of the most widely traded examples: (Source: Bankrate; Data as of the date Sept. 14th)

ProShares UltraPro Short QQQ (SQQQ)

SQQQ provides daily downside exposure to the heavily tech-weighted Nasdaq 100 index that is three times leveraged. This ETF is intended for investors who have a short-term pessimistic outlook on large-cap technology names.

Expense ratio: 0.95%

Assets under management: $4.96 billion

ProShares Short UltraShort S&P500 (SDS)

SDS offers daily downside exposure to the S&P 500 index that is double-leveraged. This ETF is intended for investors who have a short-term pessimistic outlook on large-cap U.S. firms across all industries.

Expense ratio: 0.90%

Assets under management: $964 million

Direxion Daily Semiconductor Bear 3x Shares (SOXS)

A three-times leveraged daily downside exposure to an index of semiconductor development and manufacturing businesses is offered by SOXS. Traders with a bearish short-term outlook on the semiconductor industry could use this ETF.

Expense ratio: 1.01%

Assets under management: $528 million

Direxion Daily Small Cap Bear 3X Shares (TZA)

TZA offers daily downside exposure to the small-cap Russell 2000 index that is three times leveraged. Traders with a gloomy short-term outlook on the U.S. economy may use this ETF.

Expense ratio: 1.00%

Assets under management: $445 million

ProShares UltraShort 20+ Year Treasury (TBT)

TBT provides daily downside exposure twice leveraged to the Barclays Capital U.S. 20+ Year Treasury Index. Traders who want to place a leveraged bet on rising interest rates can use this ETF.

Expense ratio: 0.90%

Assets under management: $1.14 billion