An Exchange-Traded Fund (ETF) is a financial instrument that tracks indices or a unique set of stocks in different sectors. ETFs are categorized based on various parameters, including the index they track, industry focus, commodity ETFs, currency ETFs, and so on. At the same time, there are various types of ETFs, namely leveraged ETFs, inverse ETFs, leveraged short ETFs, and so on. An inverse ETF is also known as a Short ETF or Bear ETF. Today, we will look at what inverse exposure means in ETFs.
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Meaning of Inverse Exposure
Inverse means to work in the opposite direction. An inverse exposure in ETFs means the fund is set up so that its daily performance works in the opposite direction of the performance of the underlying asset class. In simple terms, if a market index or benchmark goes down, the inverse ETF will go up by the same percentage. These inverse returns are generated by using a variety of derivative instruments including options, swaps, and futures.
Let us take an example of an ETF tracking the S&P 500 index (SPX). On a particular day, if the SPX moves down 3%, the ETF will move up 3%, in effect generating positive returns of 3%. While on another day, if the SPX is up 2%, the ETF will generate negative returns of 2%.
By their very nature, inverse ETFs are best suited for short-term trading or investment purposes. Traders often use inverse ETFs as a hedging tool. Moreover, the inverse ETFs are sometimes combined with leverage, making them leveraged short ETFs. These types of ETFs generate double (2x) or triple (3x) times the inverse returns of the benchmark. The volatile nature of these ETFs, coupled with the leverage factor (2x or 3x), makes these ETFs unsuitable for holding for longer periods.
Working Example of an Inverse ETF
The ProShares UltraPro Short QQQ (SQQQ) is a Nasdaq 100 index (NDX)-tracking inverse ETF with 3x leverage. Let’s compare the returns of SQQQ with the returns generated by the ProShares UltraPro QQQ (TQQQ), a simple 3x leveraged NDX tracking index. Both ETFs track the NDX and have 3x leverage, but SQQQ has an inverse exposure to NDX, while TQQQ moves in tandem with the index’s performance.
From the chart, it is clearly visible that the returns of both ETFs are working in opposite directions, owing to the inverse relation of the SQQQ with the NDX. When TQQQ is moving up, SQQQ is moving down, and vice versa.
List of Leading Inverse ETFs
- ProShares UltraPro Short QQQ (SQQQ)
- ProShares Short S&P500 (SH)
- Direxion Daily Semiconductor Bear 3x Shares (SOXS)
- ProShares Short QQQ (PSQ)
- Direxion Daily S&P 500 Bear 3x Shares (SPXS)
- ProShares UltraShort 20+ Year Treasury (TBT)
Key Takeaways
Inverse ETFs come with higher risk-reward potential compared to traditional ETFs. Inverse ETFs should be used only for short-term trading, as in the long term, an inverse ETF can incur huge losses. An investor must be well aware of the potential for downside risk when investing in inverse ETFs. The strategy is well suited for professional traders, especially for hedging purposes, but amateur investors might find it best to steer clear of them.
As always, investors can use the TipRanks ETF page to research and study their performance and make informed investment choices.
