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 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 them, instilling a sense of optimism in the face of market challenges.
Benefits of inverse ETFs
There are two primary benefits to 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, including:
- 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 through the S&P 500 and the VIX ETF
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 (NYSE:SH). This ETF aims to return the inverse of the daily performance of the S&P 500.
- If the S&P 500 drops 1% daily, SH should rise approximately 1%, which is what we mean by ‘inverse returns ‘. This means that for every 1% drop in the S&P 500, SH should increase by 1%. This is the basic principle behind inverse ETFs.
- If the S&P 500 rises 1%, SH will decline roughly 1%.
For more aggressive traders, leveraged inverse ETFs exist, such as ProShares UltraShort S&P 500 (NYSE:SDS), which seeks twice the inverse return (-2x).
The role of the VIX and volatility ETFs
Another way investors hedge against market downturns is through volatility ETFs tied to the VIX, or CBOE Volatility Index, 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 (NYSE: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 their risks, as they track VIX futures rather than the actual index, which can lead to significant decay over time.
Key takeaways
- Inverse S&P 500 ETFs like SH or SDS 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?
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 know how and when to use inverse ETFs. To help, here are three general rules for adding an asset to your investment portfolio.
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.
This article Trump’s tariffs, market chaos and the rise of inverse ETFs: How investors are hedging the stormoriginally appeared on Money.ca
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.
