Explore a unique variant of Exchange-Traded Funds: The Inverse ETF

Have you wondered what about the financial markets that attract so many investors? Well, profits are one of the obvious reasons, but that is not it. The variety of instruments in the market and the thrill of trading in each of them is another factor. Besides stocks and bonds, there are other interesting tools like derivatives, indexes, exchange-traded funds, etc.

In today’s article, we will discuss inverse ETFs, a type of exchange-traded fund, its features, pros and cons.

What are exchange-traded funds?

Exchange-traded funds are like mutual funds. These investment funds have a collection of assets whose performance mimics the performance of an underlier. The underlier can be stocks, bonds, indexes, etc.

For example, index ETF funds track a specific index, say NIFTY Pharma. The index ETF fund will have all the stocks that are part of NIFTY Pharma in a proportion that imitates the benchmark index’s performance. 

So, when NIFTY Pharma increases, the value of the pharma index ETF increases, too, and vice versa.

What are inverse ETFs?

Inverse ETFs are a type of exchange-traded fund, too. However, unlike regular ETFs that follow the pattern of the underlier, inverse ETFs follow an inverse pattern. So, when the underlier’s price diminishes, the inverse ETF’s value rises.

The concept of inverse ETF is similar to the contrarian approach to investing. Instead of trading with the trend, these funds follow an inverse strategy to make profits when the market is downtrending.

Examples of inverse ETFs:

Gold inverse ETF (where the underlier is gold), oil inverse ETF (where the underlier is oil), retail inverse ETF (where the underliers are stocks from the retail industry), etc.

How do inverse ETFs work?

Inverse ETFs are also called short or bear ETFs since they are quite similar to short-selling, where traders borrow assets, sell them and buy them back when prices fall.

To do so, they track the performance of the underlying asset. With the help of derivative contracts like options and futures, inverse ETF traders or fund managers enter contracts when the market is declining. Such a decline leads to a proportionate increase in inverse ETFs, benefiting the investors.

Continuing the above example, if NIFTY Pharma falls by 5%, the inverse ETF based on NIFTY Pharma rises by 5% and vice versa.

Pros and cons of investing in inverse ETFs

The benefits of trading in inverse ETFs are:

• Inverse ETFs do not require traders to maintain margin accounts or short-sell the securities. They can be bought and sold on the exchange like regular ETFs.
• Inverse ETFs are a good option to hedge traders from the risk of falling prices. Investing in inverse ETFs also brings diversification to the trader’s portfolio.
• Inverse ETFs follow various benchmark indexes, allowing investors to choose from a wide variety of options. Since it covers most of the indexes, investors can assess their risk appetite and financial goals and select the index that suits them the best.

The two significant risks of inverse ETFs are:

• The market does not always perform as expected. The inverse exchange-traded fund may not always react inversely as compared to the underlier. In such cases, investors incur heavy losses.
• Since indexes change every day, the value of the inverse ETF changes, too. Given the compounding nature of ETFs, it may not be favourable to hold inverse ETFs for a long time, as the end returns may not be as expected.

Inverse ETFs in India

India does not allow trading in inverse ETFs, as these instruments have been restricted by the Securities and Exchange Board of India. 

Trading in inverse ETFs increases speculations, which then increases volatility in stock markets. Besides, inverse ETFs are complex instruments that require special trading knowledge to protect the investor’s interest and money. Hence, inverse ETFs are currently not permitted for trading in India.

Bottomline

Inverse ETFs are a type of exchange-traded funds, investing in assets that work in the inverse direction of the underlier. So, when the underlier falls, inverse ETFs rise in the same proportion.

Though inverse ETFs are useful for holding a diverse portfolio and hedging risks in a bear market, they are complex instruments. Hence, speculating the price movements and formulating the right strategies require immense skill and knowledge. Considering the protection of investors, inverse ETFs are not allowed in India at present.

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