A Comprehensive Guide on Inverse Exchange Traded Funds

Investors seek new ways to protect their portfolios or profit during market downturns. Inverse ETFs have gained popularity as they allow traders to benefit from falling markets without directly short-selling stocks. Unlike traditional ETFs, which aim to mirror the performance of an index, inverse ETFs are designed to deliver the opposite return of the benchmark they track.

In this blog, we will explain what inverse ETFs are, how they work, their types, advantages, and risks. We will also discuss when and how investors should consider using them.

What Do Inverse ETFs Mean? 

Inverse Exchange-Traded Funds (ETFs) are a type of exchange-traded funds that are designed to generate returns opposite to the performance of an underlying index, such as the Nifty 50 or Sensex. These ETFs use derivatives like futures and options to achieve their inverse movement. If the index falls by 1%, the inverse ETF aims to rise by 1%. 

Investors commonly use them for hedging or profiting from market declines. However, their long-term performance may deviate from expectations due to daily rebalancing and compounding. Inverse ETFs in India are relatively new and not as widely available as in global markets.

How Does an Inverse ETF Work?

Inverse ETFs use financial derivatives, such as futures contracts, swaps, and options, to achieve their inverse performance. Here is how they function:

• Daily Inverse Performance: Most inverse ETFs are structured to provide the inverse return of their underlying index on a daily basis. This means they are primarily designed for short-term trading.
• Compounding Effect: When held for more than one day, the performance of an inverse ETF can diverge significantly from its expected return due to compounding effects. This makes them unsuitable for long-term investors.

Key Benefits and Drawbacks of Inverse ETFs

Here is a quick comparison of the advantages and disadvantages of inverse ETFs:

What are the Different Types of Inverse ETFs?

The following are the different types of inverse ETFs:

• Broad Market Inverse ETFs

These ETFs aim to deliver the opposite performance of major stock indices, such as the Nifty 50 or Sensex. They are used by investors who want to hedge against broad market declines.

• Sector-Specific Inverse ETFs

These target specific sectors, such as technology, financials, or energy. If an investor believes a particular sector will decline, they can invest in a sector-specific inverse ETF.

• Leveraged Inverse ETFs

These ETFs aim to provide multiple times the inverse return of their index, often by two or three times. For example, a 2x inverse ETF will move twice as much in the opposite direction of the benchmark. While they can generate significant returns in the short term, they carry substantial risk due to their amplified performance.

Benefits of Including Inverse ETFs in Your Portfolio

Investing in inverse ETFs offers several benefits, particularly for short-term traders. Here are the key benefits:

• Profit from Falling Markets: Inverse ETFs allow investors to benefit from market declines without short-selling individual stocks.
• Portfolio Hedging: They can act as a hedging tool to protect portfolios during market downturns.
• Limited Losses: Unlike short-selling, where losses can be unlimited, the maximum loss in an inverse ETF is the amount you invest.
• No Margin Required: Since inverse ETFs are bought like regular stocks, there is no need for a margin account, unlike traditional short-selling strategies.

When to Use Inverse ETFs in Your Strategy?

Inverse ETFs are most effective when used for short-term trading. Here are some scenarios where they can be useful:

• During Market Downturns: If you expect the market to decline due to negative economic news or poor earnings reports, investing in an inverse ETF can help you profit from falling prices.
• For Hedging: If you hold a portfolio of stocks and want to protect it from short-term losses, adding an inverse ETF can provide a temporary buffer.
• In Volatile Markets: During periods of high volatility, traders can use inverse ETFs to capitalise on sharp downward movements.

Risks of Investing in Inverse ETFs

While inverse ETFs offer benefits, they also come with the following risks:

• Short-Term Nature: Inverse ETFs are designed for daily trading. Holding them for extended periods can lead to performance deviations due to compounding effects.
• Higher Expense Ratios: Compared to traditional ETFs, inverse ETFs have higher expense ratios, which can eat into returns.
• Volatility Risks: In highly volatile markets, the performance of inverse ETFs can be unpredictable and may not align with the expected inverse return.

Final Words

Inverse ETFs can be a valuable tool for traders looking to profit from falling markets or hedge their portfolios. They offer a simpler and more accessible way to short the market without the need for margin accounts. However, they carry significant risks and are not ideal for long-term investors.

Before investing in inverse ETFs, it is essential to understand how they work. By using them strategically, investors can take advantage of market downturns while protecting their portfolios. If you want to explore more about ETFs or digital investment platforms, open a FREE Demat account on Torus Digital today.