A position in a traditional exchange-traded fund typically provides a long position meaning that the investor buys the ETF with the expectation that the underlying index or commodity will rise in value. However, if an investor believes that the benchmark index or commodity will fall, then an inverse ETF may be the right tool for the job.

As with traditional ETFs, inverse ETFs also trade on a public stock market. The major difference that investors need to know is that inverse ETFs are designed so that the return over short-term investment horizons are inverse that of the benchmark that the units track. Excluding the impact of fees and other costs, buying an inverse ETFs gives a result similar to short selling the stocks in the index, which means it is possible to make money when prices fall.  For example, the ProShares Short S&P 500 ETF (SH) targets a daily percentage return opposite the underlying S&P 500 index. If the S&P 500 falls by 1%, the inverse ETF should increase by 1%. Conversely, if the S&P 500 rises by 1%, the inverse ETF is expected to fall by 1%. (For more, see: Inverse ETFs Can Lift a Falling Portfolio.)

There are generally two main reasons that an investor would use an inverse ETF: hedging or speculation. Hedgers seek to reduce the risk associated with uncertainty, whereas speculators try to profit from fluctuations in the market.

Hedging

Inverse ETFs can be a good tool for investors who want to reduce risk by offsetting any gains or losses of existing holdings for a short time period. The ideal situation in hedging would be to cause one effect to cancel out another. (For more, see: What Happens if You Don't Hedge Your Investments?)

For example, suppose that an investor holds a diversified portfolio of U.S. large cap stocks. If the investor is concerned that the market may decline in the short-term then he or she may want to take steps to protect the value of his or her portfolio. One alternative would be for the investor to sell the existing holdings, but that could incur transaction costs and tax consequences. Instead, the investor may consider purchasing an inverse S&P 500 ETF to hedge the portfolio. If the basket of stocks owned by the investor fell by 1%, then the expected gains on the inverse ETF would help to offset the losses. The stock portfolio would likely not have a return identical to the S&P 500 index, so it would not be a perfect offset, but adding the inverse ETF would still reduce much of the volatility of the combined portfolio. (For more on this topic, see: Hedging with ETFs: A Cost-Effective Alternative.)

Speculation

Speculators make bets or guesses on where they believe the market is headed, and then they take a position to profit from that market movement. Profiting from falling prices is traditionally accomplished with short selling or through derivatives such as options, but this can be quite complicated for the average investor and often requires special types of investment accounts. In addition, short sales have the potential to expose an investor to unlimited losses. An inverse ETF, on the other hand, provides many of the same benefits as shorting, yet the investor is only exposed to a loss up to the purchase amount.

Inverse ETFs give speculators an alternative tool to profit from an anticipated market decline. For example, if a speculator believed that emerging markets were going to fall in the short term, he or she could purchase the ProShares Short MSCI Emerging Markets ETF (EUM) to profit from a decline in that index. (For related reading, see: A Guide for Buying ETFs on Margin.)

The Bottom Line

Inverse ETFs can be great products for people who are looking to profit from a decline in the value of an index or commodity without the complications of short selling. Inverse ETFs can be effectively added to hedge an existing portfolio, or used on their own to speculate on a market decline. (For more, see: Inverse ETFs to Own if the Market Tanks.)

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