Inverse ETFs, also known colloquially as “bear ETFs”, or “short ETFs”, are exchange-traded funds that seek to make profits from the downward movement of the underlying assets. This is to allow investors to gain from market downturns. 

Here’s how a basic inverse ETF works:

• The investment objective of an inverse ETF is to move in the opposite direction of the ETF it is inverse of. When the primary ETF goes down, the inverse ETF goes up 
• To achieve its goal, inverse ETFs use financial derivatives, such as futures, options, and swaps to profit from the downside of the target ETF 
• Inverse ETFs are rebalanced on a daily basis to achieve the opposite effect of the target ETF 
• Inverse ETFs can be highly volatile and risky and losses can be amplified when the target ETF is on an upward trend 
• Some inverse ETFs apply leverage to increase the returns from the opposite price movements of the target ETF. For example, a 2X inverse ETF aims to deliver double the opposite performance of the target ETF 
• A wide variety of inverse ETFs are available on the market that target various sectors of the economy and differ in terms of scope, geography, underlying assets, leverage, etc

Inverse ETFs serve a very important function in investor portfolios. Most investors choose inverse ETFs to either hedge against their existing positions, or to profit from an anticipated drop in an underlying index. 

For example, an investor who expects a market crash may invest in an S&P 500 inverse ETF to gain as the markets drop. In a way, it can be thought of as short selling.

Another benefit of inverse ETFs is the introduction of leverage. Many inverse ETFs are leveraged and allow investors to amplify their gains as the market dips. This is especially attractive for contrarian investors, as many such trades can result in losses while yielding lower returns. Adding leverage into the mix provides an opportunity to increase returns from such trades. 

For instance, a 3X leveraged inverse ETF of the ARKK ETF will gain triple the amount when the ETF drops. This happens because the inverse ETF is composed of short positions and put options of the target ETF/index to greatly increase the returns to investors. 

It must be noted that daily rebalancing can make inverse ETFs more attractive for short-term hedging, rather than long-term holding, which is far riskier. 

Trading Inverse ETFs

The process of trading inverse ETFs is the same as any other ETF, as shares are sold on the market, and can be bought and sold at will. 

However, what makes inverse ETFs different, is the degree of leverage, as well as the daily rebalancing that takes place. As inverse ETFs are designed to deliver the opposite performance of an underlying index, they need to be rebalanced daily to maintain a level of returns that was promised to investors. 

For example, a 2X ETF must always deliver twice the returns when the target index goes down. This is achieved by a complex strategy that involves short-selling and putting options that target the underlying index to achieve the desired return level. 

Another important factor to consider is the higher expense ratios of inverse ETFs, as opposed to regular ETFs, which can eat into your profits. 

Using Inverse ETFs During A Market Crash 

Market crashes and steep declines in indices are where inverse ETFs truly shine. A leveraged inverse ETF can greatly increase the returns from a crash - leaving investors better off despite the market being in jeopardy. 

However, it is important to note that such events can be few and far between, which makes it difficult to rely on inverse ETFs for consistent returns. This is why most investors use inverse ETFs as a means of hedging their existing portfolios to mitigate losses and possibly make extra profits during downturns. 

Let’s consider a practical example of how ETFs and inverse ETFs differ and how changing market conditions can lead to vastly different returns thanks to leverage:

• QQQ is an ETF that tracks the performance of the Nasdaq-100, which is one of the most followed stock market indices in the world
• SQQQ, or Short QQQ, is an inverse of the QQQ ETF that shorts the ETF and uses a 3X leverage to give higher returns to investors 

Now, let’s look at the performance of each ETF over the past 12 months:

The QQQ ETF has returned 19.71% over the past 12 months. 

The SQQQ has lost 55.59% over the same period. This clearly illustrates that despite the fact that these two ETFs are inversely correlated, the 3X leverage of SQQQ means that its loss potential is also three times as high as that of QQQ. 

Before investing in inverse ETFs, it is crucial to understand the inherent benefits and risks associated with doing so. Inverse ETFs are complex financial instruments that require an extensive knowledge of the markets to use profitably. 

Pros

• Hedging - Inverse ETFs are great at hedging against the downside of existing holdings. For example, an investor holding shares of QQQ can invest some of their capital in SQQQ, which shorts the Nasdaq-100 index and profits from the downside
• Accessibility - similarly to regular ETFs, inverse ETFs are also easy to access and trade on the stock market
• Hassle-free shorting - inverse ETFs remove the hassle of individual short positions and allow traders to short most major indexes without issue
• Liquidity - most inverse ETFs are highly liquid and their shares can be bought and sold on the market within seconds
• Diversification - inverse ETFs can add variety and diversity to any portfolio 

Cons

• Volatility & risk - inverse ETFs can be more volatile than regular ETFs, which adds to the downside risk for investors 
• Short-term focus - inverse ETFs have a more short-term focus, as holding them for the long term can lead to losses due to daily rebalancing and market movements 
• Leverage - while leverage increases the potential profits of inverse ETFs, it also amplifies the losses when trades don’t pan out as planned 
• Higher costs - inverse ETFs have a higher expense ratio due to being actively managed, which can eat into profits 
• Complexity - inverse ETFs are complex financial instruments that require daily rebalancing, which may not be suitable for first-time investors 

• Inverse ETFs are exchange-traded funds that track indices and aim to deliver opposite results to the underlying indices
• Inverse ETFs do this by holding short positions and put options for the underlying index to profit from the downside
• Many inverse ETFs are leveraged, which can greatly increase profits during downturns, but amplify the losses during bullish markets 
• Investors use leveraged ETFs to add diversification to their portfolios and to hedge against market downturns 
• Contrarian investors may invest in inverse ETFs in anticipation of a major crash