In today’s turbulent economic climate, marked by President Trump’s recent tariffs on Canada, Mexico and China, concerns about a potential recession are escalating.
As markets react to these developments, investors explore strategies to protect their portfolios.
One such strategy involves inverse exchange-traded funds (ETFs).
What are inverse ETFs?
Inverse ETFs, also known as bear or short ETFs, are designed to move in the opposite direction of a specific index or asset.
For example, if the S&P/TSX 60 Index declines by 2% daily, an inverse ETF tracking this index would aim to increase by approximately 2%.
This mechanism allows investors to hedge against market downturns and presents an opportunity to profit from market dips, instilling a sense of optimism in the face of market challenges.
Benefits of inverse ETFs
- Accessibility: Inverse ETFs provide a straightforward way for investors to hedge against market declines. Purchasing an inverse ETF is as simple as buying any other stock or traditional ETF through your brokerage account, giving you the power to protect your investments.
- Diversification: These ETFs cover various markets and sectors, enabling investors to target specific areas they anticipate will decline. Whether you’re bearish on the overall market, a particular industry, or even commodities like oil, there’s likely an inverse ETF available.
Risks and considerations
While inverse ETFs can be valuable tools, they come with notable risks:
- Short-Term Focus: Inverse ETFs are typically rebalanced daily, aiming to achieve their inverse returns daily. Over more extended periods, due to the effects of compounding, the performance of these ETFs can diverge significantly from the inverse of the target index’s performance. This makes them less suitable for long-term investment strategies.
- Higher Costs: Inverse ETFs often have higher expense ratios compared to traditional ETFs, which can erode returns over time.
Understanding inverse ETFs
Suppose you believe the S&P 500 is overvalued and due for a pullback. Instead of shorting individual stocks or buying put options, you could buy an inverse ETF like the ProShares Short S&P 500 ETF (SH). This ETF aims to return the inverse of the daily performance of the S&P 500.
What does this mean? It means if the S&P 500 drops 1% daily, ProShares Short S&P 500 ETF (SH) should rise approximately 1%, which is what we mean by inverse returns. So, for every 1% drop in the S&P 500, ProShares Short S&P 500 ETF (SH) should increase by 1%.
On the flipside, if the S&P 500 rises 1%, ProShares Short S&P 500 ETF (SH) will decline roughly 1%.
For more aggressive traders, leveraged inverse ETFs exist, such as ProShares UltraShort S&P 500 (SDS), offer even greater chances to profit from market downturns, as it seeks twice the inverse return (-2x).
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The role of the VIX and volatility ETFs
Another way investors hedge against market downturns is through volatility ETFs tied to the CBOE Volatility Index (VIX), often called the “fear index.” The VIX tends to spike when the market falls, making it a popular hedge.
Instead of shorting the market directly, you could buy an ETF like ProShares VIX Short-Term Futures ETF (VIXY).
- When stocks decline and fear rises, the VIX increases, and VIXY typically rises.
- When markets are calm or rising, the VIX drops, and VIXY declines.
However, VIX ETFs come with risks. VIX ETFs like VIXY or HUV do not track the VIX index itself but instead use short-term futures contracts. These are subject to contango, a condition where futures are priced higher than spot levels, leading to potential value decay even when volatility expectations rise.
How can Canadian investors use inverse ETFs?
Canadian interest in inverse and volatility ETFs has grown. According to National Bank Financial report, as of Q1 2024, inverse ETFs represented approximately 6.2% of total ETF trading volume on the TSX, up from 4.1% in 2022. This increase in use among investors indicates a rising demand for downside protection.
Canadian investors looking to hedge market downturns using a Canadian-traded ETF can consider the Horizons BetaPro S&P/TSX 60 Inverse ETF (TSX:HIX) or the Horizons BetaPro S&P 500 VIX Short-Term Futures ETF (TSX:HUV.TO), which offer inverse exposure to Canadian and U.S. markets, respectively.
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Key takeaways
- Inverse S&P 500 ETFs like SH or SDS or HIX and HUV allow investors to bet against the broader market.
- VIX ETFs offer exposure to market volatility but can erode in value due to the structure of futures contracts.
Is investing in inverse ETFs right for you?
Canadian regulators, including the Ontario Securities Commission, caution that inverse and leveraged ETFs are not suitable for most retail investors due to their daily rebalancing and high risk. They’re best used by sophisticated investors or traders with short-term horizons.
Given the complexities and risks associated with inverse ETFs, they may not be suitable for all investors. If you’re considering them as a hedge against potential market downturns, it’s crucial to:
- Understand the Product: Ensure you fully comprehend how inverse ETFs work, including their daily rebalancing feature and the implications for longer-term performance. This knowledge will empower you to make informed investment decisions, enhancing your sense of control and confidence.
- Assess Your Risk Tolerance: These instruments can be volatile and are generally intended for short-term strategies. Align their use with your risk tolerance and investment objectives.
- Consult a Financial Advisor: Before incorporating inverse ETFs into your portfolio, discuss your plans with a financial advisor to ensure they fit your investment strategy.
While inverse ETFs offer a mechanism to profit from potentially or hedge against market declines, they require careful consideration and understanding. Before proceeding, ensure they align with your investment goals and risk tolerance.
— with files from Romana King
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
