The Wikipedia definition of an inverse Exchange Traded Fund states: “An inverse exchange traded fund is an exchange traded fund (ETF), traded on a public stock market, which is designed to perform as the inverse of whatever index or benchmark it is designed to track.” Inverse ETFs work by using techniques such as short selling, swaps and trading derivatives such as futures or option contracts.

Rear view of the businessman which is standing in front of the choice 'sell or buy'

A simple example is if you were to purchase an inverse S&P 500 ETF such as the SH (Pro Shares Trust Short S&P 500 ETF), if the S&P 500 rises by 1% in a single day SH is designed to fall by 1%; and if the S&P falls by 1% in a single day, SH should theoretically rise by 1% (see risk disclosures below). They are used by both professional and private investors who are bearish of the underlying index or sector. Warning – as with any investment you should be knowledgeable about all aspects of a security before investing. A prospectus is available for all ETFs including inverse ETF from the sponsor. Information on inverse ETFs may also be found on the Securities and Exchange Commission website http://www.sec.gov/investor/pubs/leveragedetfs-alert.htm.

An inverse ETF provides many of the same benefits as shorting, yet it exposes an investor only to the loss of his or her original investment. Another advantage of inverse ETFs is that they may be held in retirement accounts, while short sales are not permitted in these accounts.

Risk Disclosures:

Actively managed: Inverse funds should be used in actively managed portfolios, never in passive/buy-and-hold portfolios. Leveraged inverse ETFs are not recommended for non-professional investors.

Fees: Inverse ETFs normally have higher fees than standard index and/or sector ETFs since the funds are, by their nature, actively managed.

Timing: Inverse ETFs are designed to be used for relatively short-term investing as part of a market timing strategy. The inverse ETF manager needs to buy when the benchmark rises and sell when it falls in order to maintain a fixed leverage ratio. These trades may result in a volatility loss proportional to the market variance. Compared to a short position with identical initial exposure, the inverse ETF will typically deliver inferior returns.

Tracking error: Inverse ETF performance may differ from their benchmark. Due to the compounding of daily returns inverse ETF performance over periods other than one day will likely differ in amount and possibly directions from the benchmark/target return for the same period. Investors should monitor their holdings in inverse ETFs to correlate with their investment strategies.

Drift: Since the risk of the inverse ETF and a fixed short position will differ significantly as the index drifts away from its initial value, differences in realized payoff have no definite or fixed correlation.

Hypothetical example (source: Wikipedia):  If one invests $100 in an inverse ETF position in an asset worth $100, and the asset’s value changes to $80 and then to $60, then the value of the inverse ETF position will increase by 20% (because the asset decreased by 20% from 100 to 80) and then increase by 25% (because the asset decreased by 25% from 80 to 60). So the ETF’s value will be $100 x 1.20 x 1.25=$150. The gain of an equivalent short position will however be $100–$60=$40, and so we see that the capital gain of the ETF outweighs the volatility loss relative to the short position. However if the market swings back to $100 again, then the net profit of the short position is zero. However, since the value of the asset increased by 67% (from $60 to $100), the inverse ETF must lose 67%, meaning it will lose $100. Thus the investment in shorts went from $100 to $140 and back to $100. The investment in the inverse ETF, however, went from $100 to $150 to $50.

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Keep in mind that past performance is not indicative of future results. In addition, there may be other Exchange Traded Products that offer exposure to the sectors mentioned and each has their unique perspectives and characteristics. It is important to determine if they are appropriate for your personal portfolio.

Disclosure: Worth Asset Management is a Registered Investment Adviser with the state of Texas. Jim Clark and/or his clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The comments and opinions offered herein are not personalized recommendations to buy, sell or hold securities.

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