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The Advantages and Disadvantages Of Inverse ETF

18 Aug 2023

Introduction

Inverse ETFs are exchange-traded funds (ETFs) that gain from a drop in the value of an underlying benchmark. They are also known as 'Bear ETFs' or 'Short ETFs.' Inverse ETFs are comparable to short positions, which means selling securities with anticipation of buying at a lower price in the future. This investment product is popular among contrarian traders who want to profit from the declining value of the benchmark index. 

Now that you have a concise understanding of this product, we will explore a few more aspects of this ETF and then discuss its advantages and disadvantages.

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How Do Inverse ETFs Work?

An inverse ETF uses financial derivatives, such as futures contracts, options, and swaps, to achieve an inverse return of the underlying index. For example, if an inverse ETF tracks the Nifty 50 index, and the value of the Nifty 50 falls by 2%, this ETF will increase by 2%. Similarly, if the Nifty 50 rises by 2%, the inverse ETF will decrease by 2%. Thus, inverse ETFs have an opposite relationship with the index they track.

Inverse ETFs aim to generate returns daily. It means that the fund manager buys and sells the derivatives contracts daily to maintain the desired exposure to the index.

Advantages Of Inverse ETFs

Some general perks of investing in these ETFs are:

  • Easy access: They provide a convenient way to take a short position on the index without borrowing or selling the underlying securities. You may buy and sell this ETF on the stock exchange like any other ETF without worrying about margin calls, interest charges, or short-selling restrictions.
  • Diversification: They allow for portfolio diversification by adding a negative correlation component. This can reduce the portfolio's overall volatility and risk, especially during market stress.
  • Low cost: They typically have lower expense ratios than other hedge funds or alternative investments that use similar strategies. They also have lower transaction costs than trading individual securities or futures contracts.
  • Flexibility: They offer a range of choices to suit your risk appetite and investment objectives. You can choose from different levels of leverage, such as 1x, 2x, or 3x, depending on how much you want to amplify your returns or losses. As an investor, you can also choose from different types of indices.

Disadvantages Of Inverse ETFs

Inverse ETFs also have drawbacks you should know before investing in them. 

  • High risk: They may cause significant losses if the market moves against your expectation. They also expose you to unlimited losses if you rely on leverage. This magnifies both the returns and losses of the fund. Moreover, inverse ETFs can suffer from tracking errors. They may not ideally mimic the underlying index's performance. This is because of the fees, rebalancing costs, liquidity issues, or market disruptions.
  • Short-term focus: They are suitable for short-term trading. They deal in daily trades that reset their exposure to the index daily. It means you can only hold inverse ETFs for longer if they lose their intended exposure to the index. Suppose you buy an inverse ETF that tracks the Nifty 50 at Rs 100 when the Nifty 50 is at 10,000 points. You hold it for a month when Nifty 50 drops to 9,000 points. You may expect your ETF to be worth Rs 111 (10% increase). However, due to the compounding effect of daily returns, your inverse ETF may be worth much less or more than Rs 111, depending on how Nifty 50 moved during that month.

Are Inverse ETFs Allowed In India?

Inverse ETFs are not allowed in India. The reason is the regulatory restrictions imposed by the SEBI. The regulatory authority has not given its approval because of the following reasons:

  • Market stability: SEBI is concerned that inverse ETFs may create instability in the market by increasing the volatility and speculation in the index. It also fears that inverse ETFs may amplify the downward pressure on the index during bearish phases. 
  • Investor protection: SEBI is also concerned about the investor protection aspect of inverse ETFs. It believes inverse ETFs may not be suitable for retail investors, as they may not always understand the risks and mechanics of these products. SEBI also thinks inverse ETFs may not be transparent enough for investors to monitor their performance and exposure to the index. SEBI also doubts the ability of the fund managers to manage the derivatives contracts efficiently and effectively without compromising the interests of the investors.

Conclusion

Inverse ETFs have several pros and cons. But what's more important to understand is they are not permissible in India. However, many experts in India argue in favor of allowing inverse ETFs. They believe that doing this will help develop the market, increase investor awareness, and create a robust regulatory framework. 

 

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