What to Know Before Buying Inverse and Short ETFs

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Investors often use inverse exchange-traded funds (ETFs) in advanced trading strategies, but they can help hedge any investor's downside risk or help open a bearish position in a commodity or sector. Due to their more complex nature, you should learn all you can about these types of funds, also known as short ETFs, before you add any to your current portfolio.

What Is an Inverse ETF?

An inverse ETF is an index ETF that gains value when its correlating index loses value. It achieves this by holding assets and derivatives, like options, that are used to create profits when the underlying index falls. The Short DOW 30 ETF (DOG) profits when the Dow Jones Industrial Average goes down. The DOG's profits are proportional to the Dow's losses.

Inverse ETFs are risky assets that you should approach with caution. That said, there are a few ways in which investors can benefit from using them.

Investors with a risky amount of exposure to a certain index, sector, or region can buy an inverse ETF to help hedge that exposure. They can use inverse ETFs in their investing strategy to gain downside exposure in the market. Buying into an inverse ETF can be a less risky way to make that bearish bet if your research has led you to take a bearish stance on an index or sector.

Advantages of Inverse ETFs

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

The 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. These investors can instead purchase shares in an inverse ETF, which gives them the same investment position they would have by shorting an ETF or index.

Inverse ETFs are thought to be riskier than traditional ETFs, but they're bought outright. This makes them less risky than other forms of bearish bets. There's often unlimited risk when an investor shorts an asset. The investor could end up losing much more than they had anticipated.

An investor can only lose as much as they paid for the ETF with inverse ETFs.

The inverse ETF becomes worthless in a worst-case scenario, but at least you won't owe anyone money, as you might when you short an asset in a traditional sense.

Disadvantages of Inverse ETFs

One of the main risks of inverse ETFs is their lack of popularity. You can buy many types of ETFs, but you won't find a huge selection of inverse ETFs. You'll likely find that inverse ETFs have less liquidity than other ETFs due to fewer options and less demand.

Another risk is that major stock indexes have historically risen when the timescale is long enough. This makes it risky to use inverse ETFs as part of a buy-and-hold strategy. History suggests that the index will bounce back sooner or later from any losses in recent years. Inverse ETF investors need to keep a close eye on the markets. They can attempt to exit their position before the corresponding index rallies.

Funds to Think About

Give some thought to the following inverse index ETFs if you want to hedge some portfolio risk or have a bearish feeling about a certain market index: Short S&P 500 (SH) inversely tracks the S&P 500 Index. Short Russell 2000 (RWM) inversely tracks the Russell 2000 Index.

Watch some other inverse ETFs if you have risk in a certain market sector or have a negative feeling about a certain industry: 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. 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. Think about both the pros and the cons. Watch the performance of some inverse ETFs before you get started.

Consult a financial professional or your broker to answer any questions or concerns you may have. Your research and due diligence are the key commodities in the world of ETF investing.

NOTE: The Balance doesn't provide tax or investment services or advice. This information is presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any one investor. It might not be right for all investors. Investing involves risk, including the loss of principal.