What is an inverse ETF and how does it work?

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Inverse ETFs have been in the news lately thanks to the recent TSX debut of the Horizons BetaPro Inverse Bitcoin ETF (BITI), which is designed to grow in value as Bitcoin’s price drop.

Whereas a traditional ETF is designed to rise and fall in lockstep with an underlying investment index like the S&P 500, an inverse ETF — also known as a bear ETF or short ETF — is meant to do the opposite.

That can be an enticing proposition, not just for professional traders but also for regular everyday investors and retirement savers who want an uncomplicated way of hedging their investing app portfolios.

Case in point: the Horizons BetaPro S&P/TSX 60 Inverse ETF (HIX), one of the more popular inverse ETFs for Canadian investors.

HIX promises a “negative 100%” return of the daily performance of the S&P/TSX 60 Index. If S&P/TSX 60 drops 2% on a given day, the HIX would pocket you a 2% gain.

So if you’re concerned that the S&P/TSX is getting heated and due for a pullback (but are still happy with the long-term outlook of your portfolio), buying some HIX might offer peace of mind. Some of the losses on your holdings will be offset by the gains in HIX.

In this way, inverse ETFs can provide short-term insurance on any long exposure you might be worried about.

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Benefits of Inverse ETFs

The S&P/TSX Composite Index is an index of the stock (equity) prices of the largest companies on the Toronto Stock Exchange (TSX) as measured by market capitalization. Up.
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The appeal is simple: they allow everyday investors like you and me to profit from a downward movement in a wide variety of markets.

Markets constantly go both up and down, after all. And for anyone who wants to bet against the overall stock market, or specific industries, resources, or even bet against cryptocurrencies like Bitcoin, there’s likely an inverse ETF out there these days to make it happen.

It certainly wasn’t always so easy. Traditionally, if you were a pessimistic, or ”bearish,” investor looking to time the market’s plunge, you’d have to short specific stocks or delve into options.

Shorting positions require an investor to own a margin account, which basically means you’re investing with borrowed money. Options, meanwhile, are fairly complicated for everyday investors.

But with inverse ETFs, going short is as easy as logging into your brokerage account and clicking the “buy” button — just as you would with a stock.

Risks of Inverse ETFs

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There’s a simple reason why I’ve emphasized the short-term benefits of inverse ETFs: They have virtually no long-term benefits.

In fact, inverse ETFs are almost certain to lose money eventually, regardless of what direction the market trades.

The reason for this lies in the fact that inverse ETFs are rebalanced on a daily basis.

The perils of daily rebalancing

Rebalancing can be a little difficult to understand in theory, so let’s use an example.

Imagine a stock index with a current value, expressed in “points,” of 10,000. Now, suppose that index falls 20%, from 10,000 to 8,000, on Day 1, and returns to 10,000 on Day 2, a gain of 25%.

If you owned a traditional ETF based on that index, your position would be at break-even.

But if you purchased an inverse ETF instead, the volatility alone would have produced a loss on your investment.

Why? Because while you gained 20% on Day 1, you lost 25% on Day 2. The index is at par; meanwhile, you’ve lost more than you gained.

This effect is bound to catch up with you eventually over the long term.

It should also be noted that while inverse ETFs are easy to get into, they come with relatively high fees, with expense ratios usually in the range of 1%. The average ETF, by contrast, carries an expense ratio of about 0.4%.

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So should you invest in inverse ETFs?

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Despite their allure, the effect of daily rebalancing means it’s tough to recommend them to novice investors.

If you really can’t help yourself, though, please proceed with caution. Don’t bite off more than you can chew. Use inverse ETFs strictly as a short-term trading tool, not as a long-term wealth-building strategy.

While inverse ETFs can be a good way to time the market and hedge your portfolio over the short run, the big money is still made by owning great businesses over the long run.

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About the Author

Brian Pacampara, CFA

Brian Pacampara, CFA

Investing Editor

Brian is an investing editor at MoneyWise. A long-time stock junkie, his work has appeared in The Motley Fool, Seeking Alpha and Yahoo Finance. He believes in owning "forever stocks" — from a rare group of businesses that have paid out dividends for decades.

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