Inverse ETF’s

An exchange trading fund (ETF) sells investors an interest in a pool of securities such as equities, bonds, currencies or commodities, not unlike a mutual fund.

Unlike a mutual fund however, an ETF trades like equity on a stock exchange which means it can be bought and sold freely during trading hours, margin trading can be used as well as techniques such as limit orders and ETF Trend Trading. An ETF normally seeks replicate the performance of a specific index.

An inverse ETF is an interesting variation of an ETF in that it seeks results that are the exact opposite of the index to which it is correlated. In other words, if the index goes up, the value of the ETF goes down and vice-versa. As an example, if you expect an index such as the S&P 500 to go down, you would buy the inverse ETF in order to profit from this decline. There are also ETF’s that seek to deliver multiples of the inverse correlation to an index. For instance,ProSharesUltraShort Russell 2000 aims to deliver twice the inverse of the Russell 2000 index.

Normally, the capital of an inverse ETF is not invested directly in underlying securities. Instead, the investment adviser invests in a complex mix of derivatives such as options, forward contracts and swaps which he believes will provide the inverse performance to the index. In addition, excess cash if any is invested in money market/short-term debt instruments that will enhance the return on the ETF.

Advantages: the main advantage of an inverse ETF is the simplicity, especially for an average investor, though the same objectives can be achieved by other means. If you feel that a particular index or industry of commodity is going to go down, buy the ETF. Then when the downtrend has run its course, sell the ETF to book your profits (remember that as the index declines, the ETF will appreciate). If you were to achieve the same result in normal trading, you actually need a short sell which you may not be able to do because you do not have the right broker or the capital to provide the margin.

Alternatively, you could achieve the same effect by taking a position in the derivatives market. Your broker also may not allow you to deal futures and options unless you demonstrate your competence. Trading in derivatives is never easy at the best of times nor does it have the simplicity and the transparency of an ETF transaction. You are also better off letting the inverse ETF investment manager handle these complex transactions on your behalf.

Disadvantages:

-if the inverse ETF investment adviser gets his calculations wrong, the ETF may not deliver the kind of inverse returns that you are looking for. This could be the result of an incorrect derivatives mix or of leverage.

-if you pick the wrong inverse ETF, you only have yourself to blame.

Inverse ETF’s make an excellent hedge for an existing investment portfolio. For instance, if you believe that the value of your existing equity portfolio is going to decline, the most straightforward manner in which you can hedge a possible loss is to buy the appropriate inverse ETF. This is far more uncomplicated than having to rebalance your portfolio by buying and selling the individual items of equity. It is also much more cost-effective.