Inverse exchange-traded fund

An inverse exchange-traded fund is an exchange-traded fund (ETF), traded on a public , which is designed to perform as the inverse of whatever index or benchmark it is designed to track. These funds work by using short selling, trading derivatives such as futures contracts, and other leveraged investment techniques.

By providing, over short investing horizons and excluding the impact of fees and other costs, performance opposite to their benchmark, inverse ETFs give a result similar to short selling the stocks in the index. An inverse S&P 500 ETF, for example, seeks a daily percentage movement opposite that of the S&P. If the S&P 500 rises by 1%, the inverse ETF is designed to fall by 1%; and if the S&P falls by 1%, the inverse ETF should rise by 1%. Because their value rises in a declining market environment, they are popular investments in bear markets.

Short sales have the potential to expose an investor to unlimited losses, whether or not the sale involves a stock or ETF. An inverse ETF, on the other hand, provides many of the same benefits as shorting, yet it exposes an investor only to the loss of the purchase price. Another advantage of inverse ETFs is that they may be held in IRA accounts, while short sales are not permitted in these accounts.

Because inverse ETFs and leveraged ETFs must change their notional every day to replicate daily returns (discussed below), their use generates trading, which is generally done at the end of the day, in the last hour of trading. Some have claimed that this trading causes increased volatility (Cheng & Madhavan 2009), while others argue that the activity is not significant (WSJ article cites dissent).

Inverse and leveraged inverse ETFs tend to have higher expense ratios than standard index ETFs, since the funds are by their nature actively managed; these costs can eat away at performance.

In a market with a long-term upward bias, profit-making opportunities are limited in long time spans. In addition, a flat or rising market means these funds might struggle to make money. Inverse ETFs are designed to be used for relatively short-term investing as part of a market timing strategy.

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