An exchange-traded fund, or ETF, is a fund that follows an index and combines the flexibility that comes with investing in stocks and the variety of an index mutual fund. An inverse ETF is an investment strategy that seeks to make a profit when prices fall. Often called a "bear ETF" or a "short ETF," it is set up to follow the inverse or opposite of whatever market it tracks. Many investors turn to inverse ETFs when the markets are falling with the goal of hedging portfolios.
Bracing for Market Drops
To invest in an inverse ETF, an investor purchases shares at the beginning of a downturn. When the investor feels the downturn is nearing an end and the market will soon swing up again, it's time to sell. The way an inverse ETF is set up is that of opposite movement of the market. When the benchmark or index falls, the value of the inverse ETF rises.
This investment strategy is similar to short selling stocks, where investors make money by getting a profit from an expected decline in the market. Unlike short selling, you don't need to create a margin account with your broker because you aren't making the short sale directly.
Not for Long-Term Investors
Inverse ETFs are not a good idea for long-term investments, as that goes against the longstanding statistical tracking of the market, which, despite short-term ups and downs, follows an upward trend over the long term. However, for those investors facing a significant downturn in the market, inverse ETFs are attractive in that they can minimize losses.
Expert investors must watch the market carefully, because, as long as prices decline, the inverse ETF will make them money. When the market hits an upswing, it's time to change investment strategies. Precise timing is needed to make inverse ETFs work for a portfolio. Unfortunately, no one can predict what will happen in the market, so an inverse ETF has no guarantees.
Inverse ETFs are not for beginning investors. They require intense management and a deep understanding of short selling for profit, hedging and market trends. Also, since inverse ETFs are a relatively new investment tool, there is little data on how inverse ETFs perform under a variety of market situations or whether they are a long-term positive contribution to the season investor's portfolio.
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