6 Things to Know About Inverse and Short ETFs

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While investors typically use these instruments in advanced trading strategies, inverse exchange-traded funds (ETFs), also known as short ETFs, can help hedge your downside risk or even help you open a bearish position in a commodity or sector. However, due to their more complex nature and investing strategies, it's important to know all you can about these types of funds before you add any to your current portfolio.

What Is an Inverse ETF?

An inverse ETF consists of various assets and derivatives, like options, used to create profits when the underlying index declines in value. Basically, it’s an index ETF that gains value when its correlating index falls. For example, the Short DOW 30 ETF (DOG) profits when the DJIA index goes down.

Advantages of Investing

Besides the usual benefits of an ETF, including ease of use, lower fees, and tax advantages, there are two other reasons inverse ETFs could fit well in your portfolio. If you have a trading or brokerage account that doesn’t allow you to short-sell assets, you can purchase an inverse ETF to give you the same investment position as you would have with a short ETF or index.

As another advantage of inverse ETFs, an investor won't have to use a margin account as he would when shorting an investment. Even though inverse ETFs act like short positions, you actually purchase the ETFs.

The Downside

One of the main risks of inverse ETFs is their lack of popularity. While you can buy many types of ETFs, you won't find a huge selection of inverse ETFs. In turn, that can lead to a lack of liquidity for some inverse ETFs.

Why Purchase an Inverse ETF?

If you have downside risk in a particular index, sector, or region, buying an inverse ETF can help hedge that exposure in your portfolio. You can also use inverse ETFs in your investing strategy to gain downside exposure in the marketplace.

If your extensive research leads you to a bearish sentiment, buying an inverse ETF will help implement your strategy without the usual risks that come with a naked short position. When you purchase an inverse ETF, you limit your risk to the price you paid for the fund. When you naked short an asset, you have theoretically unlimited upside risk.

Funds to Consider

If you want to hedge some portfolio risk or have a bearish opinion of a certain market index, consider the following inverse index ETFs for your portfolio:

  • Short S&P 500 (SH): Inversely tracks the S&P 500 Index
  • Short Russell 2000 (RWM): Inversely tracks the Russell 2000 Index

If you have risk in a particular market sector or have a negative sentiment toward a particular industry, some other inverse ETFs to watch include:

  • UltraShort Financials (SKF): Inversely tracks the Dow Jones U.S. Financial Index
  • UltraShort Industrials (SIJ): Inversely tracks the Dow Jones U.S. Industrials Index
  • UltraShort Real Estate (SRS): Inversely tracks the Dow Jones U.S. Real Estate Index

You can even invest in inverse ETFs for certain country and region indexes. Keep an eye on these:

  • UltraShort MSCI Japan (EWV): Inversely tracks the MSCI Japan Index
  • UltraShort FTSE/Xinhua China 25 (FXP): Inversely tracks the FTSE/Xinhua China 25 Index

Get Started Investing

Inverse ETFs can be a powerful tool in your investing strategy, but make sure you perform due diligence before you make any trades. Consider both the pros and cons and watch the performance of some inverse ETFs before you get started.

Once you're prepared, consult a financial professional or your broker to answer any questions or concerns you may have. Your research and due diligence are the most important commodities in the world of ETF investing.