6 Things to Know About Inverse and Short ETFs

Dow Jones logo in Times Square
400tmax / Getty Images

While they are typically used in advanced trading strategies, inverse ETFs (also known as short ETFs) can help hedge downside risk or even open a bearish position in a commodity or sector. However, it's important to know all you can about these types of funds (and notes) before you add any to your current portfolio.

What Is an Inverse ETF?

An inverse exchange traded fund in created by using various assets and derivatives (like options) in order to create profits when the underlying index declines in value.

Basically, it’s an index ETF that gains value when the correlating index falls. For example, the Short DOW 30 ETF (DOG) profits when the DJIA index goes down.

Advantages

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

Another advantage of inverse ETFs is that an investor will not have to hold a margin account as he would when shorting an investment. Even though inverse ETFs act like short positions, you are actually purchasing the funds.

Disadvantages

One of the main risks of inverse ETFs is that they are not popular. While there are many types of ETFs, there isn’t a huge selection of inverse ETFs. In turn, that can lead to a lack of liquidity for some inverse ETFs.

Why You Should 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.

Another reason to consider inverse ETFs in your investing strategy is to gain downside exposure in the marketplace. If your extensive research leads you to a bearish sentiment, the purchase of an inverse ETF will help implement that strategy without the usual risks that come with a naked short position.

When you purchase an inverse ETF, your risk is limited to the price paid for the fund. When you naked short an asset, your upside risk in theoretically unlimited.

Inverse ETFs to Consider

If you want to hedge some portfolio risk or have a bearish opinion of a certain market index, here are some inverse index ETFs to consider 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, here are some other inverse ETFs to watch.

  • UltraShort Financials (SKF) – Inversely tracks the Dow Jones U.S. Financial Index
  • UltrShort 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

There are even inverse ETFs for certain countries and region indexes. Here are some to keep an eye on.

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

Not enough for you? Then you may want to check out the complete list of inverse ETFs...

List of Inverse ETFs and ETNs

How to Get Started

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 think you are ready, I suggest consulting a financial professional or your broker to answer any questions or concerns you may have. Research is the most important commodity in the world of ETF Investing.