Inverse ETFs – which give investors a way of profiting when share markets fall – are on a tear, clocking in more trades and gathering more assets than ever before.

Despite there being only four inverse ETFs on the ASX, they accounted for 15% of ETF trades in the third quarter. This is up from just 3% the previous year.

The most popular inverse ETF – the BetaShares Australian Equities Strong Bear Hedge Fund (BBOZ) – had almost $1 billion change hands in September, making it the second most traded ETF.

Their growth however has caused some to raise the alarm. Many feel that inverse ETFs – which short sell derivatives to achieve their goals – are not really ETFs. Others worry that mum and dad investors – called “retail investors” in the industry – will misunderstand them.

According to Chris Brycki, chief executive of robo-advisor Stockspot, inverse ETFs are very speculative.

He said: “Unfortunately they tend to attract much more money after the market has already fallen and it's too late. Over the long run or even as a portfolio hedge they are risky products because of their high fees and the impact of daily compounding.”

For reasons such as these, big ETF providers have begun campaigning against them. In the US, where they are campaigning hardest, they’ve asked exchanges to ban them from being called ETFs. In Australia, they have run a small media campaign against them. But they are not gunning after them hard like they are in the US. 

If retail investors were getting hurt by inverse ETFs it would be grounds concern. But all the commotion raises some obvious questions: who is buying them? Is anyone getting hurt? And is campaigning against inverse ETFs justified?

Enter advisers 

The main users of inverse ETFs are wealth management professionals and especially advisers, BetaShares and ETF Securities have said.

The trading data suggests this is probably accurate. According to the ASX, the average trade size for the three geared inverse ETFs in September was over $25,000. These average trade sizes indicate that professionals are using them, as they tend to trade in larger chunks.

For purposes of contrast, compare this with the average trade size of $8,000 on the video games and cybersecurity ETFs. Smaller tickets suggest retail buyers.

It makes sense that professionals would be the main users of inverse ETFs. As the coronavirus has rocked markets, a lot of investors are looking for ways to protect – or profit – from the fall. But common ways of doing so – such as short selling and put options – are not available to everyone.

Adrian Rowley, a portfolio manager at Watershed Funds Management, a managed account provider, says inverse ETFs give wealth managers an easy alternative to derivatives and short selling.

“We think inverse ETFs are a really handy tool. They are good for dialling up and down your market or sector exposure with lower transaction costs," he said. 

“They are more efficient than chopping in and out of the portfolio and incurring capital gains. And because it’s leveraged you only have to use a small amount of the cash balance.”

Are retail investors harmed?

Given the majority of inverse ETF users are pros, one may feel campaigning against inverse ETFs is a bit unfair. After all, the pros know what they’re doing. But some retail investors are using inverse ETFs. And there is a genuine question as to whether they can get burnt.

The responsibility to protect retail investors primarily falls to ASIC, the financial regulator. Here, ASIC has taken two steps.

The first has been banning ETF providers from calling inverse ETFs “ETFs”. What BlackRock, Vanguard and the other big ETF providers are clamouring for in the US has been granted in Australia. ASIC requires inverse ETFs to be called hedge funds. Hence the label “ETF” does not appear in any of the inverse fund names.

Journalists – including me – refer to “inverse ETFs”. But it is not strictly accurate.

ASIC’s second step has been banning the American versions of these products. Much like America has different gun laws to Australia, America also has different inverse ETF laws. These differences are important.

American inverse ETFs – ProShares and Direxion are the biggest names – magnify and invert whatever index they follow. But they come with a tricky catch: they only do it for the day. The following morning, American inverse ETFs “reset” as if the previous day never happened.

Why is that a tricky catch? To cut a long story short, because of the way they compound, on a long enough timeline American inverse ETFs go to zero. See the graph of SPXU, above. 

What exactly is wrong with them?

Inverse ETFs are not for everyone – but absent concrete evidence they’re hurting retail investors, it is hard to say what is wrong with them.

Could it be the volatility? Plenty of other ETFs - like junior gold miners and early-phase biotechs - are very volatile too. Could it be the fact they fall in value long term? Their performance is no worse than the uranium sector ETF. Or is it the fact they’re confused with defensive index ETFs? ASIC has banned any conflation of the two.

So what, then, is to be done?

One approach, put forward by Nick Nicolaides, founder of Pearler, an online wealth platform, is to acknowledge inverse ETFs are risky and have shortcomings. But to also note they can serve a purpose for the right type of investor. Mr Nicolaides said:

“With internally managed leverage, I think these ETF issuers are doing something far more responsible… than say those offering CFDs and more broadly, trading platforms designed to gamify investing. And for the right investor, they can provide an effective hedge for market corrections in a more tax advantageous manner than taking profits on existing positions.”

It strikes me as the right approach.