Invest in Inverse ETFs to Hedge Market Downturns

An inverse ETF is made by using different kinds of derivatives to profit/gain from a decline in the market. ETFs, hold assets such as stocks, commodities or bonds that operate using an arbitrage mechanism. This is what allows these investments to trade close to their Net Asset Value (NAV). In this article, we will talk about the meaning of Inverse ETFs, how they work as well as some of their pros and cons, and the different types of ETFs while also covering when you should properly consider investing in one. We will also draw a comparison between Inverse ETFs and Short selling.

An inverse ETF is an exchange-traded fund, which is constructed to gain/ profit from the decline in value of a target benchmark. In contrast to typical ETFs – whose objective is capturing the performance of an index — an inverse ETF means that it will give you the opposite of what an index did that day. This makes it helpful for investors who seek to hedge against down market movements or speculate on the decline of certain sectors, and indices. On the flip side, inverse ETFs are specialty financial products and that means they have their inherent risks.

• Inverse ETFs are often used as a hedging tool to shield portfolios from downturns in the market.
• Inverse ETFs are usually designed to be used for a short term, mostly on a daily basis.
• Inverse ETFs are riskier than traditional (non-leveraged) ETFs because by definition they use leverage to accomplish their daily investment objectives.
• Holding inverse ETFs long-term can result in large loss of value and therefore, they are not ideal for long term investors.
• Inverse ETFs are a great way to profit off negative market sentiment or downturns in specific sectors of the market.

An ETF that is made from options, futures contracts and swaps with the intention of producing returns inversely proportional to a particular index is called inverse ETF. For example, when the Nifty 50 index falls by 1% in a day, an inverse ETF linked to Nifty 50 may rise on the same day by 1% too. These funds are intended to provide inverse daily performance so they lose effectiveness over time due to compounding, particularly when held for more than one day.

The main benefit of an inverse ETF is that it provides a way for investors to make money from the market's decline without having to short-sell. It is a convenient tool for investors who expect a bear market trend but do not want the risks or difficulties of directly shorting stocks. Also, inverse ETFs can be an easier way for someone to hedge their portfolio, providing some downside protection when the markets are on a downward trend. They are also democratized so that retail investors have access to them thus, making it simpler for a broader audience to implement market strategies.

Inverse ETFs present some drawbacks. They are primarily risky due to their duration which is short-term. Given that they are daily products, performance deviations from the expected inverse return can occur when held for a longer period. This is the outcome of daily compounding. In addition, inverse ETFs typically carry higher expense ratios than traditional ETFs reducing returns over time. Finally, they may be unsuitable for all investors especially those with a low risk tolerance or long-term investment horizon.

No, inverse ETFs have not been introduced to the Indian marketplace yet. The Securities and Exchange Board of India (SEBI) has not approved trading in inverse ETFs on Indian exchanges, essentially because they are complex products with high risk, known to be unsuitable for retail individuals. However, Indian investors can still tap into inverse ETFs by investing through international markets. This facility is provided through platforms having access to global equity trading. Indian investors can go through the rules, risks and costs of trading international inverse ETFs before investing.

Indian investors typically invest in other similar instruments like put options or futures contracts to hedge against market declines. It is essential to understand these products thoroughly which again may not be suitable for all investors.

Inverse ETFs come in a variety of types, each with the goal of tracking the inverse performance of indices. Here are the types:

• Broad market Inverse ETFs: These track indices like Nasdaq 100 and S&P 500 which have inverse performance.
• Sector-specific Inverse ETFs: These offer exposure to target areas of the market such as technology, energy or financials.
• Leveraged Inverse ETFs: These push to deliver multiples (e.g., 2x, 3x) of the inverse return on an index. Although they may provide better returns, they carry a lot of risks and therefore are not advised to keep for the long term.

Investors may buy an inverse ETF if they believe the market is due for a sell-off or are looking to hedge existing portfolio positions against potential losses. For example, in times of economic instability, such as due to geopolitical tensions or during overbought market conditions, as indicated by technical analysis, inverse ETFs can be an effective tool for capital preservation and growth.

However, an investor must be mindful of the daily reset in inverse ETFs as this poses a huge constraint on timing. In general, these funds are best used on a short-term basis with close monitoring by the investor. When an investor thinks, for example, a particular sector is going to decline in the near term due to poor earnings or due to some sort of regulatory headwind, they can purchase what's known as a sector-specific inverse ETF to benefit from the expected downturn.

Over the longer term, however, most investors are likely best to avoid inverse ETFs. This daily compounding effect can cause the fund to dramatically diverge from expected returns over longer periods. For this reason, these instruments are not ideal for traditional buy-and-hold investment strategies and should be employed only as part of a broader trading approach.

There are ways to profit from a reduction in the price of an asset, by using inverse ETFs and short selling. Most short sellers do so by borrowing shares of those stocks with the plan to sell them later after the stock has gone through its expected depreciation, thereby profiting by buying the stock again at the new lower price and thus pocketing the difference. The returns on this method can be high but so are the risks as there is no ceiling to which the price of stock can climb.

In the case of inverse ETFs though, investors can accomplish a similar goal with no borrowing requirement or short-selling complications. They offer a simpler mechanism for retail investors to short the market or sector. Moreover, a loss from an inverse ETF is limited to the investment in this structure and cannot exceed it, unlike short selling where the losses theoretically can be unlimited.

That being said, inverse ETFs have their inherent risks as well. As covered above, they have the daily reset feature which can lead to unintended and undesirable results, especially in more volatile markets. On the other hand, short selling provides more control over timing and exit strategy, which bodes better for experienced traders who practice it.

For investors seeking to hedge against market downturns, or looking to short-sell higher indices, it is critical that you understand what an inverse ETF is. Inverse ETFs make for an easy way to do this, but they are also highly risky specifically for long-term investors. Individuals need to evaluate their investment horizon/risk tolerance and also the impact of daily compounding in case they are considering an inverse ETF.

For instance, platforms like Bajaj Finance make it easier for investors to understand the nuances of inverse ETFs and other financial tools, enabling you to decide how well your investment strategy aligns with your ultimate financial objectives.

Based on your financial goals, you can choose from a plethora of mutual fund schemes and use their resources that make investing in mutual funds easy and hassle-free.