What Are Inverse ETFs?
ETFs or Exchange Traded Funds, have become a popular asset for investors of all experience levels. They are a stable and low-cost way for investors to gain exposure to a basket of stocks, an entire industry, or even an entire index. ETFs are great for passive investors who want to just park their money into an asset and let it grow over time. But they can also be a steady foundation of a portfolio for active traders as well.
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What Are Inverse ETFs?
There are thousands of different ETFs to choose from and dozens of different types as well. From sector ETFs to index funds to leveraged ETFs, there is a fund for every type of investment strategy.
But have you ever heard of an inverse ETF? Not many investors have and it is a shame because inverse ETFs have great utility in your portfolio.
This type of ETF is a fund that profits from the decline of the sector, index, or basket of stocks that it tracks. The fund utilizes derivatives and options trading to provide an investor with inverse performance. It is essentially like having a short position in an index or sector but in the form of an ETF.
It might be difficult to wrap your head around it, especially since most casual investors are not into short selling. But there are several important ways to use inverse ETFs to our advantage!
You might find it counterintuitive to want the markets to decline, but as you will see this is not always the case.
How Can I Use an Inverse ETF?
Inverse ETFs trade on the public markets like any other ETF or stock. You can buy shares of it through your brokerage, and since it is an ETF, you can even trade options. This flexibility for ETFs is exactly what makes them such a popular investment vehicle with traders.
Most inverse ETFs track the major indices or other sectors like the commodities market. Why is this? For ETF providers, it is just easier to be inversely trading against an index, rather than a basket of specific stocks. Here are a couple of ways to invest in these for your portfolio.
Buy and Hold
The simplest way to invest in an inverse ETF is to buy and hold it.
This means you should have some conviction that the underlying index will fall in the near future.
The best time to buy and hold an inverse ETF is when a market is at all-time highs.
Generally, if the market has been on a major bull run, it is likely due for a pullback.
The real question is how long you will hold an inverse ETF in your portfolio. Let’s say you own an inverse ETF that tracks the S&P 500. Of course, if the S&P 500 is at all-time highs, there is a good chance it will have some sort of sell-off at the top.
But inverse ETFs don’t perform well as markets continue to run higher. You can hold it all the way up and then hope for a big drop-off at some point.
You can also use things like technical analysis to determine what might be a good entry point. Remember, you want to enter when there is going to be a drop-off. Buying near previous resistance levels is one way to try and ‘time’ the market decline.
Use As a Hedge
This is probably the safer and more relatable way to use an inverse ETF to your advantage. For those who do not know, an investing hedge can help you limit your downside and protect the capital in your portfolio.
The simplest way to think about this is in the case of a direct hedge. A direct hedge has limited upside, but it can really hold your portfolio above water if things go sideways. Let’s use the S&P 500 as an example once again.
A passive investor puts most of their investment capital into the S&P 500 index fund, SPY. It is a simple investing strategy that millions of Americans use. The S&P 500 continues to hit new highs and the investor is looking to protect his SPY portfolio.
By buying and holding the inverse ETF for SPY, any decline in the S&P 500 will be counterbalanced by the gains from the inverse ETF. This is why it is a direct hedge.
Now, another potential example of this is for a fairly active trader who holds a diversified portfolio. Maybe they own some big tech companies, some banks, and some commodities stocks. How would you hedge this? Again, chances are most of the stocks this trader owns is in the S&P 500. They could also buy the S&P 500 inverse ETF to hedge their account.
But let’s say a greater weight of the investments is in big tech stocks. Well, why not buy the inverse ETF for QQQ, the ETF that tracks the NASDAQ. Having these options allows you to be creative with how you want to hedge your portfolio.
What Are the Best Inverse ETFs?
If you think you fall into one of the above situations, then it might be time to add inverse ETFs to your portfolio. As we found out earlier this year, a market correction can come out of nowhere and hit us hard.
The NASDAQ fell into bear market territory and the S&P 500 fell into correction territory. Now imagine if you had an inverse ETF hedge in place for both of those situations.
ProShares Short S&P 500 (SH)
The SH ETF is the most common ETF that we refer to as an inverse S&P 500 ETF.
While it isn’t exactly inverse, it does enough to counteract any sudden decline in your portfolio.
Looking at the holdings for an inverse ETF isn’t very helpful, as it is mostly cash and other assets like derivatives.
Another thing to note is that expense ratios can often cut into your long-term gains. They can also throw off the performance of the fund based on the fees you pay.
SH has a higher MER than most ETFs at 0.88%. Why is that? Inverse ETFs need to be more actively managed than traditional ETFs. Derivatives are always being rebalanced to ensure that the underlying fund stays true to its target.
ProShares UltraPro Short QQQ (SQQQ)
I’ll give you one guess as to what this ETF does. That’s right, it shorts the NASDAQ-100 index. A quick glance tells you that holding inverse ETFs over the long term isn’t the best strategy.
Those who chose to hold the SQQQ since inception are down more than 54%. This is because as equities markets continue to grow, they generally rise in value over time. For example, the S&P 500 index has an average annual return of about 10%.
But if you have a portfolio that has big tech stocks and other high-growth companies, shorting the NASDAQ-100 is a great strategy. Not forever, but just until the next correction.
SQQQ is also a 3X leveraged ETF. What does that mean? It means for every basis point the NASDAQ falls, the SQQQ rises by three basis points. This is great for investors who do not have a lot of capital and still want to hedge their tech portfolios.
ProShares UltraPro Short Dow 30 (SDOW)
Or maybe you find yourself bearish on blue-chip stocks in the Dow-30. Owing the 3X leveraged ETF SDOW can provide an excellent hedge if the Dow were to drop.
Earlier this year, the Dow Jones fell for several weeks in a row. With a 3X leveraged inverse ETF like SDOW, you would have more than made up for the losses in your portfolio.
This might seem like an advertisement for ProShares, but it’s not. They are just one of the ETF providers that offers a lot of inverse ETFs to its customers. SDOW isn’t as popular as SH or SQQQ, but if you own blue-chip stocks, it’s worth adding a small position in.
Direxion Daily CSI 300 China A Share Bear 1X Shares (CHAD)
What a mouthful this ETF is. This is an interesting inverse ETF play on the Chinese economy. Despite the volatility amongst Chinese ADRs over the past couple of years, CHAD hasn’t really taken advantage.
You would think a China-based inverse ETF would skyrocket as the economy hits multi-year lows. This isn’t really a recommendation but an example of a non-index fund inverse ETF.
As far as investment strategies go, I would say buying inverse ETFs is fairly advanced. Being invested in the US stock market is a lucrative strategy in the long term
But the short-term is filled with ups and downs, and investors who want to protect their portfolios from sudden crashes will want to equip themselves with some inverse ETFs. While inverse sector ETFs exist, it’s generally easier to just buy an inverse index ETF like SH, SQQQ, or SDOW. Owning a bit of each might just cover all of your bases!