A chance to make gains when the market falls: Understanding inverse ETFs

When the market is growing, conventional investments can benefit. But did you know that there is also a way to make money when markets fall? Enter the inverse ETF, a specialised financial tool designed to increase value when broad market indices decline.
In this article, we’ll explain what an inverse ETF is, explore its core functions, and discuss both the upsides and downsides of incorporating these instruments into your strategy.

• Table of contents

1. Understanding inverse ETFs
2. How to invest in inverse ETFs
3. Varieties of inverse ETFs
4. Benefits of inverse ETFs
5. Drawbacks of inverse ETFs
6. Inverse ETFs in India
7. Investing in inverse ETFs
8. Comparative approach: Inverse ETFs vs. short selling

Understanding inverse ETFs

The inverse ETF meaning implies that it’s a type of exchange-traded fund aiming to deliver the opposite of the daily performance of a market benchmark such as the Nifty 50. For instance, if the benchmark falls 1% on a given day, an inverse ETF tries to rise by approximately 1%. These products often rely on derivatives—like swaps or futures—to achieve their reverse exposure.

Rather than short-selling individual stocks or trading complex derivatives, investors can use an inverse exchange-traded fund (ETF) to take a short position in the market.
Since inverse ETFs rebalance or reset daily, their performance is typically measured on a day-to-day basis, not over extended periods.

How to invest in inverse ETFs

Inverse ETFs are not permitted in India. However, several international asset management companies offer this product, linked to their stock exchanges.

Varieties of inverse ETFs

Although the premise is the same—opposite performance to an index—several categories exist:

• -1x Inverse ETFs: Aim for a daily 1:1 inverse. If the underlying index loses 2%, the ETF tries to gain 2%.
• -2x or -3x leveraged inverse ETFs: Seek magnified inverse moves (two- or threefold). While they can multiply profits if the market falls, losses also accelerate if the index rises unexpectedly.
• Sector or commodity-focused: Some inverse ETFs concentrate on specific industries (like tech or financials) or commodities (like oil or gold). These allow you to bet against a particular segment rather than a broad market index.

Benefits of inverse ETFs

Advantages of inverse ETF revolve around risk management and opportunity:

• Short exposure made simple: Instead of opening a margin account and short-selling individual stocks or indices, you can buy an inverse ETF in your regular brokerage account.
• Limited liability: In typical short-selling scenarios, losses can be theoretically unlimited. But with an inverse ETF, your loss is limited to the amount you invested in the fund.
• Intraday liquidity: As with standard ETFs, inverse ETFs trade on stock exchanges throughout market hours, giving you flexibility to enter or exit quickly.
• Portfolio hedging: If you anticipate a downturn, adding inverse ETFs can offset some of your other holdings’ downward pressure.

Drawbacks of inverse ETFs

While these products can be helpful, they come with caveats:

• Daily reset: An inverse ETF resets daily. This means that at the end of each trading day, the fund recalculates its exposure to ensure it continues targeting the opposite of the next day's index return. This involves adjusting holdings in futures, swaps, or other derivatives to maintain the intended leverage (-1x, -2x, etc.) Since this process happens daily, over time, there can be value erosion.
• Volatile performance: Leveraged inverse ETFs, especially -2x or -3x, can produce extreme swings. If the market surges, an aggressive leveraged inverse ETF can plummet much faster.
• Short-term focus: These products usually cater to traders or hedgers. Long-term investors seeking stable inverse exposure may find the daily reset aspect problematic.

Inverse ETFs in India

Because inverse ETFs hinge on derivatives, regulators worldwide impose unique rules on their issuance. In India, the Securities and Exchange Board of India (SEBI) has been cautious about leveraged and inverse products. At the moment, inverse ETFs are not permitted in India.

Investing in inverse ETFs

Deciding when to buy an inverse ETF depends on both your market outlook and risk appetite:

• Anticipating market downturn: Traders who foresee a market correction might use inverse ETFs to profit from falling prices.
• Short-term hedge: If you hold significant equity exposure, a short-term hedge with an inverse ETF can mitigate the impact of temporary market dips.
• Event-driven: Certain scheduled events (e.g., earnings seasons, budget announcements) might trigger volatility. Inverse ETFs can be used to capture or mitigate these short-lived moves.

However, due to daily resets and compounding effects, holding these products for prolonged periods can generate unintended outcomes, especially if markets oscillate.

Comparative approach: Inverse ETFs vs. short selling

Although inverse ETFs vs. short selling both aim to benefit from dropping prices, they are not the same:

Aspect	Inverse ETFs	Short selling
Accessibility	Can be purchased via a standard brokerage account	Requires margin accounts and broker permissions for shorting
Exposure	Gains from the entire index or sector in inverse form	Concentrated short on specific stocks (or indices)
Risk profile	Limited to the ETF investment (can lose max total cost)	Loss potential is unlimited if stock rises significantly
Costs	Expense ratios apply	Borrowing fees and margin interest apply, plus commissions
Reset frequency	Daily reset affects compounding over multiple sessions	No automatic reset; short positions remain until closed

Conclusion

Inverse ETFs can provide a way to potentially gain from or hedge against falling markets without resorting to traditional short-selling. While they can cushion the portfolio during periods of expected downward volatility, the daily reset mechanic demands careful monitoring. Prospective investors should evaluate the product’s leveraged or unleveraged nature, expense ratios, and their personal time horizon before taking the plunge. An inverse ETF works is more suitable as a short-term hedge or tactical play, rather than a permanent long-term holding.

FAQs:

Is it a good idea to buy an inverse ETF?

It can be, provided you predict near-term market drops and plan to manage it actively. Because of daily resets and potential compounding distortions, inverse ETFs suit short-term strategies or precise hedging, not extended holding. Moreover, they are not offered by India and investors can only purchase them from international AMCs.

What is the difference between ETF and inverse ETF?

A standard ETF tracks the same direction as its underlying index. An inverse ETF, in contrast, attempts to replicate the opposite daily return. Thus, if an index falls 2%, the inverse ETF aims to rise 2%.

Who buys inverse ETFs?

Primarily traders and sophisticated investors seeking short-term market downturn gains or hedging. Long-term, buy-and-hold investors rarely use them because of resetting complexities and potential mismatch with extended goals.

Can an inverse ETF go to zero?

If the underlying index experiences sustained, significant upward momentum, an inverse ETF’s value might drop drastically. While hitting exactly zero is rare, extreme volatility could erode its worth over time.

How long can I hold an inverse ETF?

Technically, there’s no fixed limit. However, due to the daily reset effect, holding periods are usually shorter. They’re usually considered more suitable for daily or brief trades rather than multi-month positions.

Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
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