What Are Inverse ETFs?

The average investor roots for a bull market. After all, a rising tide lifts all boats. However, some investors take a different approach. Rather than buy traditional assets and hold long positions, a contrarian investor may seek to profit during a market downturn by purchasing inverse ETFs.

Unlike standard exchange-traded funds (ETFs), inverse ETFs seek to profit when their underlying indices decline. We’ll examine inverse ETFs to see how they differ from short selling, explore different types, and examine their pros and cons.¹

What are inverse ETFs?

Also known as short ETFs or bear ETFs, inverse ETFs contain various derivative assets that aim to perform conversely to a target index. Derivatives commonly found in inverse ETFs include options, futures, and swap contracts.

Inverse ETFs allow investors to profit by betting that particular market sectors, commodities, or currencies will decline. Traders typically hold inverse ETFs as short-term investments or use them to hedge existing long positions during bearish periods. 

(Composer makes it easy to find the best inverse ETFs for a bear market. See how by signing up for a 14-day free trial today.)

Inverse ETFs vs. short selling

Short selling refers to selling an asset that you do not own. Short sellers borrow securities with the expectation that they will return the shares in the future. Although shorting stock and inverse ETF strategies can both profit during market downturns, they differ in several key aspects. 

Ease of access

Short selling requires a margin account, which enables you to borrow money from a brokerage. Without a margin account, you cannot short sell stock. Trading inverse ETFs does not require a margin account, making the strategy more accessible to retail investors. 

Risk management

If a stock you short keeps rising in price, you could incur limitless losses. Sudden price surges can also force you to buy shares to cover your short position, pushing the price even higher. When you purchase inverse ETFs, you limit your risk to the amount invested. 

Costs

Short selling involves several costs, including account fees, trading commissions, and interest on borrowed shares. Other hidden costs include dividend risk. If you short a stock that pays a dividend, you must pay the dividend in cash to whoever loaned you the shares.

Although inverse ETFs can incur commissions and charge higher expense ratios than traditional ETFs, buying inverse ETFs costs significantly less than short selling. 

Leverage

Short selling gives investors leverage because you don’t need to cover the total initial investment. However, leverage is typically limited to between two and four times the trade value, depending on the brokerage, the security you wish to short, and your account standing.

Inverse ETFs provide comparable leverage that does not vary between brokers or fluctuate according to your margin requirements. 

Types of inverse ETFs

Inverse ETFs come in several types, including the following:

Single inverse ETFs

Single inverse ETFs attempt to invert the performance of a target index. If the target index rises by 1%, the inverse ETF declines by 1%. Conversely, a 1% decline in the index means the inverse ETF will increase by 1%. 

Some single inverse ETFs track specific assets, such as inverse bond ETFs, while others track particular indices, like the Russell 2000 small-cap equities index. Others follow a novel basket of equities, such as the Inverse Cramer Tracker ETF (SJIM), which attempts to provide the opposite results of recommendations from popular TV host Jim Cramer. 

Leveraged inverse ETFs

Unlike single inverse ETFs, which aim for directly correlated performance, leveraged inverse ETFs utilize debt to offer magnified inverse returns. In US markets, inverse leveraged ETFs can offer double to triple leverage on your initial investment.

For example, if a target index declines 1%, a triple-leveraged inverse ETF will rise (roughly) 3%. Leveraged inverse ETFs grant investors greater exposure than single inverse ETFs, making them ideal for highly aggressive bearish trading strategies. 

Sector-specific inverse ETFs

Sector-specific inverse ETFs offer opposite returns to economic sectors like energy, healthcare, or technology. For example, an inverse bank ETF provides inverse exposure to the banking sector.

By targeting particular industries, sector-specific inverse ETFs grant you greater control over your trading strategy. You can better capitalize on sector declines and focus your short-term hedging strategy.

Commodity inverse ETFs

Commodity inverse ETFs provide inverse exposure to commodities benchmarks. These benchmarks track commodity prices for products like precious metals, agricultural products, and oil. Commodity inverse ETFs allow investors to indirectly participate in commodities markets without buying futures contracts or physical assets like gold. 

Currency inverse ETFs

Currency inverse ETFs allow investors to bet that a foreign currency will fall in value compared to other currencies. These ETFs provide investors exposure to currency markets without buying foreign currencies or trading forex. 

Volatility inverse ETFs

Volatility inverse ETFs, such as the Simplify Volatility Premium ETF (SVOL), try to invert the performance of indices that track volatility, like the VIX (CBOE Volatility Index). Investors typically use these ETFs to hedge against market uncertainty or during periods when markets exhibit low overall volatility. 

Pros and cons of inverse ETFs

Inverse ETFs offer various advantages and disadvantages that depend on economic conditions and the individual investor. 

Pros of inverse ETFs

• Hedging against market declines: Inverse ETFs allow investors to hedge their long positions in a bear market, limiting potential losses and portfolio depreciation. 

• Accessibility and liquidity: Regular investors can readily access inverse ETFs because they trade on exchanges like the Nasdaq Stock Market. Inverse ETFs also offer sufficient liquidity thanks to their heavy trading volume and narrow spreads, enabling investors to easily enter and exit trades.

• Diversification: Inverse ETFs provide investors a convenient way to diversify their portfolios by providing exposure to various sectors, commodities, and currencies without directly purchasing derivative financial products.

• Profit potential in bear markets: With careful timing, investors can profit during a market or sector downturn by buying inverse ETFs.

Cons of inverse ETFs

• Compounding effects: Inverse ETFs attempt to provide consistent inverse returns to a target index. However, their reliance on derivatives can lead to performance deviations over time, resulting in unexpected returns. 

• Leverage risk: Although leveraged inverse ETFs offer higher potential returns, they carry equally high risk. If the market surges, leveraged inverse ETFs may experience losses several times greater than non-leveraged ETFs. 

• Short-term focus: Most investors use inverse ETFs for short-term hedging strategies, which limits their potential to compound returns. Stock markets tend to steadily increase over long periods, making inverse ETFs unsuitable as long-term investments.

• Management fees: Although inverse ETFs cost less than short selling, they typically charge higher expense ratios than traditional ETFs. These fees impact their profitability over time. 

• Complexity: Inverse ETFs rely on complex derivative products like futures contracts and swaps. When you add leverage and compounding effects, it’s unlikely for beginner (or even intermediate) investors to consistently win by trading inverse ETFs. 

How to invest in inverse ETFs with Composer

Follow these steps to incorporate inverse ETFs into an automated trading strategy using Composer: 

1. Sign up to Composer for free

You can sign up in minutes and start creating investing strategies—no coding experience required. You don’t have to fund your account to backtest strategies, and Composer offers a 14-day free trial, so you can test the platform to see if it's right for you. 

2. Create a new symphony

After you create your account, click the “Create” button in the top left corner of the home page, then click “+ New Symphony” to create a new strategy. Alternatively, check out the “Discover” tab to try out pre-built approaches made by Composer staff and community members. 

3. Use the AI tool to build your symphony

Click “Create with AI” to harness Composer’s powerful AI tool. Using natural language, you can prompt the ChatGPT-4-powered tool to build inverse ETF trading strategies focused on a specific sector, commodity, or volatility. Ask the tool to include ETFs from providers such as ProShares, Direxion, or Advisorshares for more specificity.

Ready to get started? Sign up for Composer today to incorporate inverse ETFs into your trading strategy.