Short ETFs: Profiting from market downturns

Short and leveraged ETFs allow investors to magnify the return of their investments. 

Short ETFs – also known as inverse ETFs – are designed to profit from a decline in the value of an underlying index or asset. They achieve this by using derivatives such as futures contracts. 

An investor in a short position will profit if the value of the ETF goes down, contrasting a more conventional long position, where an investor profits from a rise in the value of the ETF. 

This mechanism allows investors to hedge their portfolios against market downturns or to speculate on negative market movements without the need to directly short sell, which can introduce added risk. 

For example, if an investor uses a -1x short ETF, a 3% decline in the value of the underlying assets would translate to a 3% daily increase in the ETF's value. 

Conversely, if the underlying asset rises by 3%, the ETF's value would decrease by 3% for that day. 

Leveraged ETFs: Amplifying gains

Leveraged ETFs – also known as geared ETFs – multiply both the positive and negative returns of an investment, typically by two or three times. They do this by using financial derivatives and debt, structured to amplify gains from positive movements in the index.

Financial derivatives that leveraged ETFs use can be futures contracts, index futures or swap agreements. Using financial derivatives means the ETF can be rebalanced daily.

Leveraged ETFs can amplify gains but can equally swing the other way to losses. For example, a 3x leveraged ETF based on the FTSE 100 aims to triple the daily performance of the index. If the FTSE 100 rises by 1% during a trading day, the ETF will return 3%.

In contrast, if the FTSE falls by 1%, the ETF would lose 3%.

Daily rebalancing

A key consideration when using short or leveraged ETFs is the impact of daily rebalancing. Because these ETFs reset their exposure daily to maintain their targeted leverage or inverse relationship, their performance can diverge significantly from the long-term performance of their underlying index, especially in volatile markets.

For leveraged ETFs, fluctuations in asset value – first rising, then falling – typically result in greater losses than those experienced by the underlying asset due to compounding effects.  

Each gain increases the ETF’s value, amplifying any subsequent losses. Conversely, after a loss, gains are applied to a diminished amount, which mutes their impact. Over time, this cycle can substantially diminish returns.

The benefits of leveraged ETFs include less cash needed to hit a target level of exposure.

Short ETFs offer the advantage of hedging against potential losses or gains associated with a long position, thereby providing greater predictability in future pricing irrespective of market fluctuations.

In addition, short ETFs allow investors to profit when the market is declining.