In the past few years, exchange traded funds (ETFs) have become even more versatile with the addition of leveraged and inverse ETFs. These funds allow investors to short the related indexes without technically having to short a financial asset. That means you can buy on bearish or bullish sentiment.
Toni Turner of TradingMarkets.com offers two examples of such funds. The first one is ProShares Short Dow 30 (NYSEArca: DOG), which has a one-to-one inverse correlation to the Dow Jones Industrial average. If the Dow falls 5 points, DOG rises 5. The second one is ProShares UltraShort Dow 30 (NYSEArca: DXD), which has a two-to-one inverse correlation to the Dow. If the Dow falls 10 points, DXD rises 20.
Direxion took this formula a step further, giving triple leverage in such funds as Direxion Daily Large Cap Bull 3x Shares (NYSEArca: BGU) and Direxion Daily Energy Bear 3x Shares (NYSEArca: ERY).
But…all investors should use leveraged funds carefully and recognize that they’re not for everyone.
The two strategies Turner outlines for the use of inverse ETFs are pure profit plays and hedging against market risk:
- If you are bearish on a particular sector or the broader market, you can use inverse ETFs to profit on the downside potential.
- On the other hand, if you are long on a particular stock, you can use inverse ETFs to protect yourself from market downside risk without needing to unload your holdings. For example, if you owned a large amount of Apple (NASDAQ: AAPL) in 2007, you could have bought shares in ProShares Short QQQ (NYSEArca: PSQ) and dampened the huge losses in 2008.
Although inverse ETFs are a great way to invest on bearish sentiment and provide ways to capture the gains of a leveraged portfolio without actually borrowing money, as evidenced by DXD, there are a few things to consider. [Everything You Need to Know About Leveraged and Inverse ETFs.]
- Inverse ETFs open a few minutes after the market opens and close a few minutes before the market closes, which results in slight deviations in a fund’s performance compared to the index it tracks.
- Although ETFs are priced to the NAV about every 15 seconds, there will be slight deviations from the NAV depending on supply and demand.
- All investors need to know that these funds reset daily, which over long periods of time can result in a degree of tracking error (the longer the holding time, the more pronounced this effect becomes).
For more stories on different types of ETFs, visit our ETF 101 category.
Sumin Kim contributed to this article.