The pros and cons of using inverse ETFs

They’re a good tactical alternative to shorting single stocks — but there are still downsides

The pros and cons of using inverse ETFs

While shorting can offer investors an additional avenue for returns over long-only strategies, the strategy isn’t without risk. Inverse ETFs, also known as short ETFs or bear ETFs, are a way to make anti-equity bets more safely — or at least, to a less risky extent.

“A short ETF uses derivative instruments to bet against the market,” explained Matt Frankel, CFP, in an interview with the Motley Fool. “The point of an inverse ETF is to deliver the exact opposite of an index's daily performance.”

Emphasizing that short ETF bets are based on daily price movements, Frankel said buying a short ETF limits your downside to the amount you invested. In contrast, shorting an individual stock or actually shorting an ETF exposes the investor to unlimited loss potential.

But he also identified other factors that bear ETF investors must keep in mind. “For one thing, the market definitely has an upside bias over the long term,” he said, noting that stocks outperform other asset classes over long periods of time. “This works against you if you're planning on buying a short position as a hedge to hold for a long period of time.”

Fees are another variable. In the low-cost environment enabled by index-based investments, many investors may not be used to the costs of inverse ETFs. To take one Canadian example at random, the Horizons BetaPro S&P/TSX 60 daily inverse ETF comes with a management fee of 1.15%.

“Those two factors -- the market's inherent upward bias and the fees you're paying for buying the ETF in the first place -- both combine to put you at a disadvantage,” Frankel said.

Short ETF buyers must also have the stomach to endure the outsized effect of losses. If an investor buys a short ETF and it loses 50% in value, it has to advance by 100% just to for the investor to break even. Because of the daily price movements that inverse ETFs are exposed to, such loss bias is even more important to consider.

“If you're buying a stock because you think it's going to go up like crazy in the next month, or you're investing in the S&P, a short ETF can help you hedge against that risk if you use it correctly,” Frankel said.