An inverse exchange-traded fund (or ETF) is a fund that aims to deliver the opposite return of an underlying index over a specific time period.
Unlike an ETF that tracks, for example, the performance of the FTSE 100 - which goes up in price when the FTSE 100 goes up - an inverse ETF should increase in value when the FTSE 100 decreases in value. An inverse ETF should decrease in value when the FTSE 100 increases in value.
Investors use inverse ETFs to protect (or hedge) their portfolio, but also to attempt to profit from falling prices.
For example, if your portfolio comprises stocks in the FTSE 100, you may be concerned about that index declining in value. One way to protect against those losses might be to purchase shares in an inverse FTSE 100 ETF.
If the FTSE 100 declines in value (and the shares you hold also decline), your investment in the inverse ETF should increase in value, helping to limit your losses.
However if the FTSE 100 increases in value, and continues to go up in value, then your investment in that inverse ETF will decline in value, resulting in potentially significant losses.
While an ETF tracking the FTSE 100 usually owns shares in the companies that comprise that index, an inverse ETF uses derivative contracts (swaps or futures) in order to generate the opposite performance.
Read more: What is an ETF?
Although inverse ETFs are available to retail investors, most providers recommend that investors have a more advanced understanding of financial markets. Before purchasing, it’s important to understand the risks and have a clear idea of your objectives for buying the product.
Counterparty risk means that the person or institution on the other side of a derivative transaction may be unwilling or unable to meet its obligations. This could lead to a substantial decline in the value of the contract, negatively impacting the performance of the fund. Fund regulations typically include limits on the proportion of a fund that can be exposed to a single counterparty in a transaction in order to mitigate this risk.
These products are designed to be held for a very short period of time (sometimes just a day). If you hold the asset for longer than a day, you must keep in mind that the performance of the fund may not continue to be exactly opposite to the performance of the underlying index.
To put that another way, investors need to time the purchase and sale of an inverse ETF well in order to generate a positive return. There’s a significant risk of losses accumulating if you put too large a portion of your portfolio into an inverse ETF and time your entry and exit poorly.