Lesson ETFs 201

Inverse ETFs

Inverse ETFs are made up of various derivatives to profit from declines in the values of the underlying assets or benchmarks. Inverse ETFs are often called Bear, or Short ETFs.

Inverse exchange-traded funds (ETFs) are a type of security made up of derivatives (like futures and options) and debt. They are designed to profit from a decline in the value of an underlying index, asset class or other benchmark.

Inverse ETFs seek opposite returns of their traditional counterparts. These inverse ETFs are sometimes called “Bear” or “Short” ETFs.

For example:

  • If a traditional Nasdaq-100 ETF declines by 2% in a day, the inverse ETF tracking the same Nasdaq-100 index will gain 2%
  • If a traditional Nasdaq-100 ETF rises by 3% in a day, the inverse ETF tracking the same Nasdaq-100 index will lose 3%

Inverse ETFs are also sometimes leveraged, which means that their performance targets a 2:1 (double) or even 3:1 (triple) ratio for their daily return on equity. Inverse leveraged ETFs work similarly to their non-inverse leveraged counterparts, they just provide opposite returns, these leveraged ETFs are explained in more detail in the article above.

For example: If a traditional Nasdaq-100 ETF declines by 2% in a day, the 3x leveraged inverse ETF tracking the same Nasdaq-100 index will gain 6%.

How are inverse ETFs made?

shorting inverse icon

Fund managers of inverse ETFs attempt to achieve an inverse (opposite) return on equity of the underlying index/asset class using a combination of debt, derivatives, and sometimes equity.

These funds usually target daily performance, and after fees and transaction costs for the fund managers, these funds may potentially underperform if held for a longer period of time.

For example: Some inverse ETFs that use options and futures contracts must “roll-over” or close their positions due to these contracts expiring. Due to the significant contract premiums, and costs of borrowing or utilizing margin by the fund managers, these funds usually do not track exact inverse or opposite returns of their respective non-inverse ETFs over longer time periods.

Inverse ETFs are generally used as short-term investments by most traders due to these factors.

You can always look up an ETF’s Fund Fact Sheet ahead of time on the issuer’s website for more information about a specific ETF you’re interested in.

The pros and cons of inverse ETFs

One of the main advantages of inverse ETFs is the ability to trade these in registered accounts (like a TFSA or RRSP). Normally, in a registered account, you cannot short sell a security to profit from a decline in share price (due to CRA rules).

Inverse ETFs however can be bought and sold in all accounts, thus giving you negative exposure to common asset classes, indices, or other benchmarks in an alternative way.

Check out some of the other common benefits and drawbacks of inverse ETFs below:

Benefits of inverse ETFs

Risks or downsides of inverse ETFs
Gain short exposure in registered accounts. You can profit off a decline in price of an index, or other underlying asset with an ETF.. Higher than average Management Expense Ratios (MERs) compared to traditional ETFs.
Can be used as a hedging tool to “protect” other parts of your portfolio against declines in common asset classes or indices. Sometimes may underperform if held for longer periods of time. These funds are generally created to generate inverse returns on a daily basis.
Inverse ETFs are available for a large variety of major market indices, common asset classes, and even commodities. Inverse ETFs (especially leveraged funds) may lead to larger than expected losses in a short amount of time if the market moves against you.
 

Note: The information in this blog is for educational purposes only and should not be used or construed as financial or investment advice by any individual. Information obtained from third parties is believed to be reliable, but no representations or warranty, expressed or implied, is made by Questrade, Inc., its affiliates or any other person to its accuracy.

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