An inverse ETF is an exchange-traded fund (ETF) that aims to achieve the opposite performance of its underlying index or asset. They are also known as short ETFs or bearish ETFs.

Inverse ETFs are designed for investors who believe the underlying asset’s price will decline. For example, if an investor assumes that the price of gold will fall, they could invest in an ETF that tracks the price of gold inversely.

It's essential to understand how inverse ETFs work before investing. Some inverse products are leveraged ETFs that can dramatically magnify returns, both positive and negative. They are complex financial instruments and may not be suitable for all investors.

How inverse ETFs work

Inverse ETFs use a variety of strategies to capitalize on falling prices. Some use derivatives such as short selling and futures contracts, while others use a combination of investments to achieve their objective.

Inverse ETFs are designed to go up when the underlying security goes down and provide investors with a bearish alternative to shorting stock or trading options. Therefore, you would buy an inverse ETF if you think the stock or index will go down because the ETF’s price will increase, as its price has a direct negative correlation to the underlying asset’s performance.

Inverse ETFs are designed to achieve their stated objective on a daily basis. For example, if an inverse ETF tracks the S&P 500, it attempts to return the opposite of the daily performance of the S&P 500. If the S&P 500 index goes up 1% for the day, the ETF aims to lose 1%. If the S&P 500 index goes down 1% for the day, the ETF’s goal is to gain 1%. 

The daily objective is important because, similar to leveraged ETFs, price moves over longer holding periods may result in performance divergence from investor expectations.

Benefits of inverse ETFs

Inverse ETFs can be used to hedge your portfolio against market volatility. Because they capitalize on declining price action, inverse ETFs can protect bullish investments from a market drop. 

For example, if you own a portfolio of stocks, you could purchase an inverse ETF on a major market index to offset potential losses in your stock portfolio. The proportion of long stock to inverse ETF allocation would depend on the amount of risk one is trying to hedge. 

Inverse ETFs give investors access to bearish exposure and can be used for speculation if you believe that the market will go down. Unlike shorting stock and trading options, inverse ETFs are available to all investors.

However, inverse ETFs are not perfect substitutes for shorting individual stocks or stock indices. Shorting involves selling borrowed shares in the hope of repurchasing them at a lower price so that the difference can be realized as profit. 

While inverse ETFs do not require borrowing and do not have the same risks as shorting, the compounding of daily returns can cause the intermediate or long-term performance of an inverse ETF to diverge from the performance of outright shorting a stock or index.