When the stock market falls, we all lose money. Right? No one likes red days. But, you can’t help or avoid one. That’s where the Inverse ETFs pitches in. When the markets are red, Inverse ETFs are green.
As much we want the stock market to stay green, red days are inevitable. What goes up, must come down, but eventually, we all win by holding the blue chips long term.
Inverse ETFs are an alternative to mutual funds. People like mutual funds for transparency, traceability, minimal management fees and other benefits it offers.
With Inverse ETFs, you can make daily profits if the right strategies are applied and you have good eyes for the market before trading to minimize loss.
So what exactly are Inverse ETFs? Let’s find that out in this article.
What Are Inverse ETFs?
Inverse Exchange Traded Fund (ETF) is a public stock market where you trade to make profits by countering the index it is set up to track.
In this kind of trading, you make money by predicting a market decline/crash or use any other derivatives to profit from such.
Investing in Inverse ETFs no doubt will increase your profits but you should also trade with caution to avoid risking your assets and incurring great losses.
Therefore, before you start investing in Inverse ETFs you should weigh the pros and cons involved carefully.
Examples of Inverse ETFs:
1. ProShares Short S&P 500 (NYSEMKT: SH) – ProShares Short S&P 500 (NYSEMKT: SH) is designed to match the daily returns of the S&P 500 index, but in the opposite direction. On a day when the S&P 500 rises by 3%, this ETF will fall by the same percentage (Inverse, as the name implies).
2. Direxion Daily Small Cap Bear 3X Shares (NYSEMKT: TZA) – Direxion Daily Small Cap Bear 3X Shares (NYSEMKT: TZA) is designed to produce returns three times the inverse of the Russell 2000’s daily performance. In other words, if the Russell 2000 drops by 2% tomorrow, TZA should gain roughly 6%. That’s massive gains right there.
Pros of Inverse ETFs
1. No margin account
When investing in Inverse ETFs, you are not mandated to have a margin account unless you want to short sell ETFs, and that is one of its advantages.
A margin account requires investors to borrow funds from lenders to buy securities or other financial products to increase financial leverage.
Moreover, It increases the investor’s purchasing power and return on investment but poses a greater risk as the investor may lose more than expected.
Hence, with Inverse ETFs, you can limit these risks by using cash only account where you trade according to what you have.
2. Less risky
Simply put, Inverse ETFs allow you to buy directly with the funds you have. Thus eliminating any need to short sell which can further lead to unlimited risks.
Therefore, when comparing Inverse ETFs with other forms of bearish bets, you are likely to limit your loss.
Besides, all you may have to lose is the funds invested. You do not need to pay for other losses such as the funds borrowed or collateral.
3. You own the market
The financial markets offer many types of Inverse ETFs such as ProShares Short Oil & Gas, ProShares Short Russell2000, ProShares Short QQQ, ProShares UltraShort S&P 500 and so on.
These markets help to increases the options for many investors to make money when the stock market crashes.
More importantly, most types of ETFs are passively managed which implies you are more focused on owning the markets than beating them.
Finally, you are in charge of making decisions about any underlying portfolio rather than depending on the opinions of the portfolio manager.
Passively managed portfolios like ETFs may not attract much profit as actively managed ones but they are more tax efficient.
Capital gain is the profit made from a sold asset that has appreciated over some time, and which must be claimed on income taxes.
In general, ETFs do not generate capital gains taxes except when the investor makes a sell, by selling their shares to make a profit.
Like mutual funds, ETFs investors create capital gain by selling its appreciated assets, but unlike it, it pays very little percentage as capital gain even if it is over the same time frame.
In order words, this is very good for beginners. Although it may have very little turnover, it does not require much work when trying to sell your stock to another investor.
5. Immediate dividend re-investment
In trading and investment like ETFs, a dividend is an important factor as it reflects the individual’s or company’s value in terms of financial strength and performance.
Inverse ETFs, just like many other ETFs pay out a full dividend from the funds they held. However, the way the ETFs issuer pays it is entirely up to them.
Some do pay their investors monthly, quarterly or yearly and it can be with cash or by reinvesting their dividend immediately into the ETF and this is a plus.
Furthermore, Immediate dividend re-investment helps to eliminate dividend drag that arises from non-automatically re-invested ETFs.
6. Lower cost
In comparison to mutual funds, Inverse ETFs require minimal cost as there may be a little or no need for fund management, shareholder accounting, and board of directors, marketing, sales and distribution load fees.
Mostly, ETFs simply do not attract many fees like mutual funds although they may attract an average expense ratio of 1%, which can take a bigger bite out of your return after a while.
Just like stocks, investors can buy and sell ETFs in the open market; it will likely require little commission each time they trade although some may be commission-free.
Also, extra charges may be incurred each time you reinvest your dividend unless the ETFs come with an automatic dividend plan.
Nonetheless, ETF trading does not have much effect on funds as it requires low operational costs and eliminates the need for fund liquidation and much documentation.
Other pros of Inverse ETFs include the ability to hedge your portfolio and ease of use. It is a lot easier compared to other kinds of trading methods like shorting where investors gain profits from a market decline.
Cons of Inverse ETFs
1. Short hold-time
Inverse ETFs is a short-term trading and investment plan (an intra-day trade), which you can only hold for a day.
It is designed to provide the daily inverse of its underlying index. Therefore, if you hold it for a short while, you are better off.
However, if you are a long-term investor, the best option is to steer clear of investing in Inverse ETFs especially leveraged ETFs.
Moreover, they are much likely to perform very poorly in the long run even if it is for periods longer than a day unless you actively manage it to prevent the risks involved.
When it comes to hedging your portfolio, holding your products for a day may seem very difficult and stressful.
2. Quick loss
In inverse ETFs, you are bound to lose from incurring compounding loss, correlation risks, trading commissions, and other factors that can cripple your capital if you fail to understand how it works.
As previously stated, losses in Inverse ETFs are mostly minimal. However, investors are likely to lose very quickly if they bet wrong or use a poor strategy.
A few of the instances include investing in products long-term when you should actually hold them for a short time as much as a day. Remember, Inverse ETFs are designed so that you can actively manage them by monitoring your daily holdings in order to reduce risks.
Also, if you predict wrongly by the investment market increasing instead of declining or crashing, you are likely to use all you have traded. Even more, if you short an asset, you will lose terribly.
3. Leverage Risks
For investors that may want to trade larger shares with less capital for the benefits of amplifying returns and gaining a favourable tax treatment, leveraging may be the best option.
While it may sound like a great opportunity, it should best be left for professional traders who fully understand the risks involved and strategies that will yield better results.
When you trade on Inverse ETFs with leverage, you are bound to get multiple investment returns when there is a market decline.
In the same vein, you will lose tremendously when you predict wrong; losing much more than you would when you do not leverage the products.
That is to say, that leverage magnifies both your gain and loss. It comes with greater operational risks for most companies.
4. Low dividend yield
As you might know, dividends help companies or individuals to generate additional income.
The dividend yield in the Inverse ETFs is extremely low. Now, this alone might be a major drawback for many investors out there who may want to hold long-term.
It has a much lower dividend compared to owning a group of stocks.
Moreover, ETFs need lesser time and discourages excess trading activity that impacts negatively on investment returns.
A higher dividend means more income but it may not always be a good sign as the company or individual returns a very good percentage of its profits to investors.
Conversely, low dividend yield can improve the growth of a company through re-investment and it will also be easier to pay investors than when they are high.
However, most investors want the biggest payout they can get without considering that it may not be favourable in the long run.
Every form of investment comes with a risk; while they are important to help you make better decisions that are favourable, they can also create a dip hole in your pocket when neglected.
Finally, Inverse ETFs are an alternative for those who want to invest the opposite way as opposed to the normal way other investors do.
Nonetheless, understanding the risks and rewards it offers will enable you to make better decisions to know if it will make an addition to your portfolio or not.
Thanks for reading, please let me know your thoughts and comments below.
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Sagar Sridhar is a personal finance blogger from Canada. His genuine passion for personal finance coupled with his unique style of writing is what stands out. Professionally, he is a computer engineer, agile certified and has a master’s degree in Project Management. His writing has been featured or quoted in the leading Canadian publications such as Credit Canada and many other personal finance publications. While he is juggling between his day job and blogging, he is the main author on this blog and has miles to go before making the final pit stop.