What to Know Before Buying 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 any investor's downside risk or help open a bearish position in a commodity or sector. However, due to their more complex nature, 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 is essentially an index ETF that gains value when its correlating index loses value. It achieves this by holding various assets and derivatives, like options, used to create profits when the underlying index falls. For example, the Short DOW 30 ETF (DOG) profits when the Dow Jones Industrial Average goes down, and the DOG's profits are proportional to the Dow's losses.

Inverse ETFs are risky assets that investors should approach with caution. That said, there are a few scenarios in which investors may benefit from considering them.

Investors with a risky amount of exposure to a particular index, sector, or region, can buy an inverse ETF to help hedge that exposure in their portfolio. Investors can use inverse ETFs in their investing strategy to gain downside exposure in the marketplace. If extensive research has led an investor to take a bearish stance on an index or sector, buying into an inverse ETF can be a relatively less risky way to make that bearish bet.

Advantages of Inverse ETFs

Inverse ETFs enjoy many of the same benefits of a standard ETF, including ease of use, lower fees, and tax advantages.

The specific benefits of inverse ETFs have to do with the alternative ways of placing bearish bets. Not everyone has a trading or brokerage account that allows them to short-sell assets, for example. Those investors can instead purchase shares in an inverse ETF, which essentially gives them the same investment position as they would have by shorting an ETF or index.

Although inverse ETFs are considered riskier than traditional ETFs, they are bought outright, which makes them relatively less risky than other forms of bearish bets. When an investor shorts an asset, there is theoretically unlimited risk, and the investor could end up losing much more than they had anticipated. With inverse ETFs, on the other hand, an investor can only lose as much as they paid for the ETF. In an absolute worst-case scenario, the inverse ETF becomes worthless—but at least you won't owe anyone money, as you might when shorting an asset in a traditional sense.

Disadvantages to Inverse ETFs

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. With fewer options and less demand, you'll likely find that inverse ETFs have less liquidity than other ETFs. For example, the ProShares inverse ETF tracking the S&P 500 (SH) has an average daily trading volume of a little more than 6 million as of November 5, 2020. That's significantly less than the SPDR S&P 500 ETF (SPY), which has an average daily volume of more than 90 million during the same time period.

Another risk is that, on a long enough timescale, major stock indexes have historically risen.  That means that it's risky to use inverse ETFs as part of a buy-and-hold strategy—history suggests that the index will eventually bounce back from any losses in recent years. Inverse ETF investors need to pay close attention to the markets and attempt to exit their position before the corresponding index rallies.

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 China 50 (FXP): Inversely tracks the FTSE China 50 Index

The Bottom Line

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.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.