For active, risk-tolerant traders, an advantageous element of the proliferation of exchange-traded funds (ETFs) is the ability to establish short positions on broad market indexes, sectors, regions and other asset classes without having to use old school shorting techniques.

Thank inverse ETFs for that. Inverse ETFs, also known as “short ETFs” or “bear ETFs,” usually hold a basket of derivatives, including futures and swaps, that allow the fund to establish short exposure on a particular index or sector. Today, there are hundreds of inverse ETFs trading in the U.S. allowing investors to short everything from the S&P 500 to utilities stocks to U.S. government bonds.

Prior to inverse ETFs, traders looking to establish bearish positions would have to, among other strategies, short individual stocks. Shorting individual stocks is risky on a number of levels, not the least of which is the potential for unlimited upside, which would punish shorts. Additionally, individual investors looking to short single stocks may have to borrow on margin and possibly pay hard-to-borrow fees, making a bearish trade costly.

Put options have are another favorite idea for bearish positions, but in this case, traders have to get the trade before the options expire whereas time constraints are not a factor with inverse ETFs. While inverse ETFs should not be held for extended time frames, some traders do hold these products for several weeks, opting for inverse ETFs over put options.

Clearing Up Some Confusion

Among other issues associated with inverse ETFs, one primary source of confusions stems from the fact that inverse ETFs are often mentioned alongside leveraged ETFs. Perhaps that is attributable to the fact that two of the largest issuers of leveraged ETFs in the U.S., ProShares and Direxion, are also major issuers of inverse ETFs.

However, leveraged ETFs are different than inverse ETFs. For example, many leveraged ETFs are bullish plays. Second, and perhaps another source of confusion, is that there are plenty of inverse leveraged ETFs. In either case, leveraged ETFs are used to magnify the returns of an index, sector or other asset over an intraday time frame. A triple-leveraged bullish S&P 500 ETF should return 3% on a day when the S&P 500 rises 1%. Conversely, a triple-leveraged bearish S&P 500 ETF should rise 3% on a day when the index falls 1%.

Put simply, not all inverse ETFs are leveraged. An unleveraged inverse ETF will, in a perfect world, deliver 1% of the daily inverse returns of the benchmark it is designed to track. For example, an unleveraged S&P 500 ETF will rise 1% on a day when the S&P 500 declines 1%.

Leveraged ETFs are best used as daily instruments and the same can be said of inverse ETFs due to the daily re-jiggering necessary to make these products function.

“Direxion rebalances exposure daily by buying or selling swaps to ensure that each fund tracks as closely as possible to 300% or 200% (or 300%, 200% or 100% of the inverse in the case of a bear fund) of the benchmark’s daily performance,” according to Direxion.

What's On Tap?

While inverse ETFs make for a practical way of putting on bearish positions and are less volatile than inverse leveraged ETFs, the universe of unleveraged inverse ETFs is far smaller than leveraged inverse funds. For example, Direxion offers 12 unleveraged inverse ETFs.

For bearish traders, the good news is that a wide array of market segments can be tapped with unleveraged inverse ETFs. Direxion's inverse ETFs allow traders to get bearish on the S&P 500, energy stocks, European banks, utilities and bonds, among others, all without employing leverage. ProShares offers 18 inverse but not leveraged ETFs, spanning sectors, regions and fixed income.

The ProShares Short S&P 500 (SH) is currently the largest inverse ETF and one of just two inverse or inverse leveraged ETFs with over $1 billion in assets under management. There are dozens of inverse ETFs from both issuers that are have well over $100 million in assets under management, underscoring the popularity of this unique group of bearish funds.

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