Show pageOld revisionsBacklinksBack to top This page is read only. You can view the source, but not change it. Ask your administrator if you think this is wrong. ======Inverse ETFs====== Inverse ETFs (also known as 'Short ETFs' or 'Bear ETFs') are a type of [[Exchange-Traded Fund]] (ETF) designed to go up when a specific market index or asset goes down, and vice-versa. Think of them as a way to bet against the market. If the S&P 500 falls by 1% on a given day, a -1x S&P 500 Inverse ETF aims to rise by 1% that same day. They achieve this reverse performance not by actually shorting stocks, but by using complex financial instruments called [[derivatives]], such as [[futures contract]]s and [[swap]]s. However, there's a critical catch that makes them unsuitable for most investors: they are designed to achieve their objective on a **daily** basis. This daily reset mechanism creates a [[compounding]] effect that can cause the fund's long-term performance to stray wildly from the simple inverse of the benchmark's performance. For this reason, Inverse ETFs are high-risk, short-term trading tools, not a "buy-and-hold" investment. ===== How Do Inverse ETFs Work? ===== Understanding the engine behind these products is key to understanding their risks. They aren't magic; they're complex financial machinery. ==== The Magic of Derivatives ==== Unlike a traditional ETF that holds the actual stocks of an index, an Inverse ETF doesn't engage in widespread [[short selling]] of those stocks. Instead, the fund manager enters into contracts with financial institutions (like big banks) to gain inverse exposure. These instruments can include: * **Futures Contracts:** Agreements to buy or sell an asset at a future date for an agreed-upon price. The fund can sell index futures to profit from a falling market. * **Options:** Contracts giving the right, but not the obligation, to buy or sell an asset. The fund can use [[put option]]s to bet on a decline. * **Swap Agreements:** The most common tool. The fund agrees to "swap" returns with a counterparty. For example, the fund might pay the counterparty a small, fixed fee in exchange for receiving a payment equal to the inverse of the S&P 500's daily return. ==== The Daily Reset: A Crucial Catch ==== This is the single most important concept to grasp about Inverse ETFs. Their goal is to deliver the inverse of the index's return for **one day only**. The next day, the process resets. This daily reset has a powerful and often detrimental effect over time, especially in a volatile market. Let's see a simple example: Imagine an index starts at 100 points, and a corresponding Inverse ETF starts at $100. * **Day 1:** The index rises 10% to 110. The Inverse ETF falls 10% to $90. So far, so good. * **Day 2:** The index falls back to 100. This is a drop of about 9.1% from its new level of 110. The Inverse ETF should therefore //rise// by 9.1%. * **Calculation:** $90 x 1.091 = $98.19. **The result?** The index is exactly where it started (100), but the Inverse ETF is now worth only $98.19, having lost nearly 2% of its value. This "compounding decay" or "beta slippage" means that in a choppy, sideways market, an Inverse ETF can lose money even if the underlying index ends up flat. ===== The Dangers for the Value Investor ===== From a [[value investing]] perspective, which champions long-term ownership of great businesses, Inverse ETFs are a minefield. They encourage market timing and speculation, the very habits that legendary investors like [[Warren Buffett]] and [[Benjamin Graham]] warned against. ==== Speculation, Not Investment ==== Inverse ETFs are instruments for short-term speculation on market direction, not long-term investment in economic value. A value investor buys a stock because they believe the underlying business is worth more than its current price. They are buying a share of future earnings and assets. An Inverse ETF has no underlying productive assets; it is a pure bet on price movement, disconnected from business fundamentals. ==== The Cost of Complexity ==== This complexity comes at a price. Inverse ETFs typically have a much higher [[expense ratio]] than a simple passive index fund. The management, trading, and derivative contracts required to maintain the daily inverse exposure are expensive, and these costs are passed on to the investor, eating away at returns over time. Furthermore, the reliance on swaps introduces [[counterparty risk]]—the risk that the other side of the agreement (the bank) could fail to meet its obligation. ===== A Note on Leveraged Inverse ETFs ===== If Inverse ETFs are dangerous, their super-charged cousins, [[Leveraged and Inverse ETFs]], are financial dynamite. These products aim to deliver -2x or -3x the daily return of an index. This means a 1% drop in the index is supposed to lead to a 2% or 3% gain in the ETF for that day. However, the compounding decay we discussed earlier is magnified exponentially. These funds are almost mathematically guaranteed to lose value over the long run and can be completely wiped out in periods of extreme volatility. They are suitable only for the most sophisticated (and daring) day traders. ===== Capipedia's Bottom Line ===== Inverse ETFs are complex, costly, and designed for very short-term, speculative bets on market direction. The daily reset mechanism makes their long-term performance unpredictable and often poor, especially in volatile markets. For the ordinary investor following a value-based philosophy, the lesson is simple: **Stay away.** Your time is better spent searching for wonderful businesses at fair prices than trying to time the market's daily whims with these treacherous instruments. Understanding them is useful, but primarily as a lesson in what //not// to own.