Is Inverse ETF the Ultimate Protection?

On the surface, maybe yes; technically, no.

Photo by Maria Teneva on Unsplash

An inverse ETF aka Short or Bear ETF is constructed with the intention to profit from a declining index using numerous derivatives. This allows an investor to benefit from a downturn without having to exercise any options commonly known as short selling.

Generally, short selling means you are betting against the stock and placing a position where you expect the prices to fall. In layman terms, you are borrowing someone else’s shares today at a higher price and selling it. You will then return the share to the lender by (hopefully) purchasing the share at a later point when the price of the share goes down and pocket the difference. The only problem with shorting is it comes with the risk of unlimited losses.

But with an inverse ETF, it can be traded just like any other shares or ETFs on the stock exchange over your regular brokerage account. There is no need for an investor to maintain a margin account and thus you would not lose more than your initial investment. Up until this point this would’ve been the ideal hedging form in your portfolio, right? Let’s take a closer look.

The first thing with inverse ETF is the substantially higher fees, usually around the ballpark figure of 1% as it is an actively managed fund. If you think you’re just holding it for a short period of time and the fees won’t matter much to you, then perhaps you should reconsider your intention of getting an inverse ETF as opposed to direct short selling.

With an inverse ETF, they are mostly leveraged. It is pretty complicated as it attempts to achieve targeted return (usually 2x or 3x) using various financial engineering techniques such as equity swaps, derivatives, and rebalancing. Without going much into detail due to its complexity (and I’m not an expert), in order to recoup losses, you will require a higher gain percentage than the original percentage lost. A 10% fall will require an 11% gain to fully recover, a 20% fall requires a 25% gain, and a 50% fall requires a 100% gain to get back even. Simple to say, the return of the fund does not exactly mirror the opposite of the index.

With an inverse ETF, a mere buy-and-hold strategy will not work as it still requires professional judgment on when to enter and exit. Also another note to follow will be the liquidity on the market as getting in and out of the fund at a fair price may be challenging.

The bottom line is that it can be useful if you are pretty sure of the direction of the underlying index of the ETF, and do note that high volatility will perhaps cause more harm than good. As a novice investor myself I prefer to stay out of inverse ETF, only because it is like pitching the unknown with an unknown.

If this is not of your preference, do you hedge your portfolio with gold, precious metal, or currencies?

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