Do you open the newspaper every day and silently curse the finance editors for making gloomy market predictions? Or the constant news of an impending apocalypse is making you question your investment strategy? In either case, there is a way to benefit from these doomsday-like news pieces by investing in the right fund- inverse exchange-traded funds.
While the rest of the world is counting on the markets thriving, you can hedge your bets based on the markets declining by investing in an inverse ETF.
How does that make sense? Well, let us explain.
What is an Inverse ETF?
Let’s break up the term ‘inverse ETF’ to understand it. An ETF is an exchange-traded fund. It is a bunch of securities such as stocks which track a benchmark index. For example, a NIFTY 50 ETF tracks the NIFTY 50 index. So, if an investor holds units of the NIFTY 50 ETF, they will be praying for the NIFTY 50 to gain. This will result in the value of the underlying assets that the ETF is tracking, and the investor will benefit from this gain if they decide to sell.
Now, let’s look at the specifier’ inverse’. As the name indicates, this type of ETF gains when the performance of the index it is tracking drops. So, if there is a NIFTY 50 inverse ETF, then the investor holding units of this inverse ETF fund will jump with joy when the Bloomberg reporter solemnly informs that the NIFTY 50 has lost a point or few.
It is constructed using derivatives such as futures contracts, options, swaps amongst others. An inverse ETF is also called as a ‘short ETF’ or ‘bear ETF’. In financial market terms, a market is ‘bear’ when it experiences price declines.
How Do Inverse ETFs Work?
Inverse ETF banks on its derivatives to bring profits to its investors. Typically, inverse ETFs invest in daily futures. A futures or futures contract is an agreement between two parties to buy or sell a security or asset at a predetermined time in the future at a predetermined price. The investor/ fund manager enters a futures contract betting that the market will decline. If the index falls 2 percent, the inverse ETF rises by 2 percent.
Since the inverse ETF is based on derivatives such as futures contracts which are traded daily, an inverse ETF is a short-term investment.
What are Leveraged Inverse ETFs?
Feeling extremely sure about the downward direction of the benchmark index? Well, if your confidence, knowledge, and risk-taking appetite agree, you can amplify the performance of your inverse ETF by leveraging it. Apart from derivatives, you can use debt to amplify the returns of the index.
A leveraged inverse ETF can boost the returns to the tune of 2:1 or even 3:1. This means that if the NIFTY 50 from the earlier example loses 3 percent, then your 3x leveraged inverse ETF will gain 9 percent.
Potential Benefits of Inverse ETFs
There are two significant benefits of an inverse ETF:
It is a hedge against the conventional ETFs in your investment portfolio. For example, if you have conventional ETFs tracking a benchmark index, then having an inverse ETF tied to the same index means that in case the index loses points, your inverse ETF still makes up for the loss and more.
If the investor wishes to short a particular stock but don’t have the funds for it and don’t want to use a margin account with their broker, they can invest in an inverse ETF instead. This way, even if things don’t go their way, they don’t have anything more than their principal to lose, unlike in a margin account where the investor can also lose their collateral.
Advantages of Inverse ETFs
Investing in inverse ETFs offers several advantages:
Accessibility: Inverse ETFs provide a straightforward way to take a short position on an index without the need to borrow or sell the underlying assets. You can trade these ETFs on the stock exchange just like any other ETF, eliminating concerns about margin calls, interest expenses, or short-selling restrictions.
Diversification: These ETFs allow you to diversify your portfolio by adding assets that negatively correlate with the market. This diversification can help reduce overall portfolio risk and volatility, especially during market downturns.
Cost-Effectiveness: Inverse ETFs generally have lower expense ratios compared to hedge funds or other alternative investments that employ similar strategies. Additionally, they often come with lower transaction costs than trading individual securities or futures contracts.
Flexibility: Inverse ETFs offer a variety of options to match your risk tolerance and investment goals. You can select different levels of leverage, such as 1x, 2x, or 3x, depending on how much you wish to amplify your potential returns or losses.
Disadvantages of Inverse ETFs
However, there are certain risks associated with inverse ETFs:
High Risk: Inverse ETFs can lead to substantial losses if the market moves contrary to your expectations. The use of leverage in these funds can magnify both gains and losses. Additionally, inverse ETFs may experience tracking errors, meaning they may not accurately replicate the performance of the underlying index due to factors like fees, rebalancing costs, liquidity challenges, or market disruptions.
Short-Term Focus: Inverse ETFs are designed for short-term trading and reset their exposure to the index daily. Holding these ETFs for extended periods may cause them to lose their intended correlation with the index. For instance, if you purchase an inverse ETF tracking the Nifty 50 at ₹1,000 when the index is at 20,000 points and hold it for a month as the index drops to 19,000 points, you might expect the ETF to increase to ₹1,050 (a 5% rise).
Are Inverse ETFs Allowed in India?
Inverse ETFs are not allowed in India, primarily due to regulations imposed by SEBI. The regulatory authority has withheld approval for the following reasons:
Market Stability: SEBI is concerned that inverse ETFs could destabilise the market by increasing volatility and encouraging speculation on the index. There is also a fear that these ETFs might exacerbate downward pressure on the index during bearish market conditions.
Investor Protection: SEBI also considers the potential risks to investors, particularly retail investors who may not fully understand the complexities and risks of inverse ETFs. Concerns include the transparency of these products, the ability of investors to monitor performance, and the capability of fund managers to effectively manage derivative contracts without compromising investor interests.
Conclusion
You now have an overall understanding of what and how an inverse ETF works. To understand if it has a place in your investment portfolio, reach out to Angel One, one of the leading brokerage houses in India, for a thorough assessment of your investment needs.
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