How Does an Inverse ETF Work?

Many investors have begun to realize the power of the inverse ETF (exchange-traded fund). An inverse ETF is an investment vehicle that essentially allows you to bet against the market. While savvy investors have been doing this for years, the mainstream investor is now becoming aware of this ability thanks to inverse ETFs. An inverse ETF actually profits if the index that it tracks goes down. This makes it the exact opposite of your normal ETF. While these investments can be beneficial, there are a few drawbacks to them as well. In order to understand if this type of investment is for you, here are a few things to consider. 

What Makes Up an Inverse ETF?

With the traditional ETF, you are actually investing in a number of stocks and other assets that make up the ETF. The ETF owns thousands upon thousands of shares in actual companies. However, with an inverse ETF, you are not actually buying shares in individual assets in the same way. 

An inverse ETF profits if the price of the assets that it is tracking goes down. Therefore, in order to make money off of a decrease, the ETF fund managers have to employ some investment methods that would be unorthodox for a typical ETF. An inverse ETF may hold several different options on the underlying stocks. With the option contracts, they are betting that the price of the assets will go down, and therefore, they are selling them short. They can also buy swaps from another investment house involved in the market. 

The price of the ETF is determined by the value of the options that make up the portfolio and the market itself. ETFs are traded on an exchange and only sell for what investors are willing to pay for them. 

Benefits of Inverse ETFs

  • Profit from down markets--Sometimes it seems as if everything you invest in goes down. When the market is bad like this, you can take advantage of the situation with inverse ETFs. When you think that things are going to go down in price, instead of just taking the hit with everyone else, buy an inverse ETF and make some money.
  • Hedge your portfolio--The funds in your portfolio have taken a long time to get to where they are. If you want to keep your portfolio in a good position, you need to use some hedging methods. Buying shares in an inverse ETF can protect your portfolio and give you some peace of mind. You no longer have to worry about the market going south.

Drawbacks of Inverse ETFs

  • Against long-term wisdom--When you buy inverse ETFs, you are betting against the market. Historically, the market has always gone up over the long-term. Investing in inverse ETFs is a losing proposition in the long-term.
  • Higher fees--Investing in inverse ETFs is more expensive than investing in a regular ETF. Therefore, you will have to pay more money than you typically would and eat into your profits. 
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