Matt, let's talk a little bit about what a short ETF is and how it works. The actual mechanism of it is kind of complicated. The point of an inverse ETF is to deliver the exact opposite of an index's daily performance. It's a good way to bet against the market on a short-term basis. Again, it's based on daily price movements. As our listener said, you're buying a short ETF instead of shorting an individual stock or actually shorting an ETF, that does limit the downside to what your investment is.
That's bad, but it's definitely better than unlimited loss potential.
There are some benefits to using inverse ETFs, but there are some big risks as well.
On the negative side, there are things that skew the odds against you when shorting an index. For one thing, the market definitely has an upside bias over the long term. You've probably heard that over long periods of time, no asset class outperforms stocks. It's absolutely true. This works against you if you're planning on buying a short position as a hedge to hold for a long period of time.
In addition, when you buy a short ETF, you have to worry about fees, just like you would when you buy a mutual fund or regular ETF. It has an expense ratio of 0. 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. That's something that investors definitely need to worry about. The other thing is the daily price movements. These daily movements mean your investments need to go up by a lot more than you're losing just to break even, is the basic way to say it.
There's a few things that put you at a disadvantage when shorting. Yes, shorting an entire index definitely limits your downside. But it's still not a great idea from a long-term perspective, is the point of what I'm saying. Jones: Absolutely. Matt, who would you say, in terms of the type of investors that short ETFs are most suited for, what types of investors should go after that particular strategy? They're good ways to hedge against short-term trades.
Today, you can find leveraged and inverse ETFs associated with virtually every important broad market benchmark, macroeconomic sector and most key industry groups. The first unique characteristic of inverse ETFs is self-evident: Inverse ETFs seek investment results that correspond to the inverse opposite of the benchmark, or index, with which they are associated.
If you anticipate a downturn in the Nasdaq , you would simply buy shares in PSQ. Another unique characteristic is the use of derivative instruments. Exchange-listed futures and options on futures contracts, swaps and forward agreements, and listed options on individual securities and securities indexes are typically used. The investment advisor to the ETF will trade or invest in derivative instruments that he or she believes will deliver the performance stated by each ETF using directional, non-directional, arbitrage, hedging and other strategies.
Usually, investment capital held in the legal trust underlying each inverse ETF is not invested directly in the securities of the associated index's constituents, unlike long-oriented ETFs. The yields associated with these debt instruments contribute to the portfolio's total return and can be used as collateral margin for open derivative positions. A number of inverse ETFs seek to deliver returns that are multiples of the benchmark, or of the benchmark's inverse. These funds accomplish this objective by deploying a number of complex investment strategies, often involving leverage.
Leverage can be an advantage or a disadvantage, depending on your perspective. Leverage in inverse ETFs involves borrowing investment capital for investment or speculative positions that are quite small relative to the position's overall exposure to fluctuations in price and potential for outsized rates of return.
Inverse ETFs Can Lift a Falling Portfolio
These techniques are considered aggressive and are not suitable for all investors. Investing in inverse ETFs is quite simple. If you are bearish on a particular market, sector or industry, you simply buy shares in the corresponding ETF. To exit the position when you think the downturn has run its course, simply place an order to sell. Investors obviously still need to be right in their market forecast in order to profit. If the market moves against you, these shares will fall in price.
Because you are buying in anticipation of a downturn and not selling anything short the advisor to the ETF is doing that on your behalf , a margin account is not required. Selling shares short involves borrowing from your broker on margin.
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Costs associated with selling short are therefore avoided. Successful short selling requires a great deal of skill and experience. Short covering rallies can appear out of nowhere and quickly erase profitable short positions.
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Most brokerage firms will not permit investors to engage in complex investment strategies involving futures and options unless the investor can demonstrate the knowledge and experience necessary to understand the risks inherent in these strategies and instruments. Because futures and options are limited in duration and quickly erode in price as you approach expiration , you can be right on your market call but still wind up losing all or most of your investment capital.
Is Shorting With Inverse ETFs a Smart Idea? | The Motley Fool
Thanks to the proliferation of inverse ETFs, less experienced investors are no longer precluded from gaining exposure to these strategies. Inverse ETFs also provide access to professional investment management. It is extremely difficult to successfully trade options, futures, sell short or speculate in the financial markets. Through these funds, investors can gain exposure to a host of sophisticated trading strategies and delegate a portion of their investment management responsibilities to the investment advisor overseeing the ETF.
The two main risks of inverse ETFs are leverage and asset management responsibilities. Leverage: Because trading derivatives involves margin, creating leverage, certain undesirable situations can arise. Leveraged futures positions can and do fluctuate dramatically in price.
These wild price swings can lead to inefficient markets , resulting in inaccurately priced positions within the ETF portfolio. This can eventually lead to ETF share prices that are not precisely correlated with the underlying benchmark. In addition, inverse ETF investment performance may ultimately lag performance generated by investments in the underlying securities and derivatives directly.
Under these circumstances, inverse ETF investing may result in lower-than-expected overall rates of return. If these instruments are an integral part of your overall investment strategy, lower-than-expected rates of return could impede your ability to reach the goals established at the onset of your financial plan. Asset Management Responsibilities: Investing in inverse ETFs does not relieve an investor of the duty to make informed investment decisions.
The decision of when to enter and exit markets, sectors and industries must be made at the investor's portfolio level. That means you or your financial advisor will bear that responsibility.
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If you buy an inverse ETF and the market associated with your fund rises, you will lose money. If the fund is leveraged, you could experience dramatic losses. Market downturns and bear markets are entirely different than rising markets. Inverse ETFs can be used to open speculative positions in markets, sectors or industries - or they can be used within the context of an investment portfolio. They are ideal for strategies designed to enhance the performance of a strategically allocated portfolio that is typically designed to achieve a specific goal accumulation for retirement, charitable giving, etc.