How do ETFs work?
Your guide to how ETFs work and whether this type of investment is right for you.
Read more…An exchange-traded fund (ETF) is a basket of funds and an investment product that helps investors decrease costs while amplifying the diversification of holdings. Like the stock market, an investor can choose to go long with ETF investments — buy and hold while waiting for the value of the pooled funds to increase — or short the market using ETFs.
For instance, if an investor believes the S&P 500 will drop during the next month, they could invest in an inverse ETF that would rise in value should the S&P 500 go down.
This makes inverse ETFs ideal for investors who want to profit during market downturns. However, to maximize investment returns, you must first appreciate how an inverse ETF in Canada works before learning the best strategies and tactics for shorting the market using ETFs.
Inverse ETFs are exchange-traded funds (ETFs) built with derivatives such as futures contracts. These ETFs aim to generate a daily performance that moves in the opposite direction of a particular index, for example, the S&P 500. You can buy and sell shares in an inverse ETF through a brokerage account using the same process as buying a traditional ETF.
There are two main types of inverse ETFs in Canada:
Inverse ETFs are also called short ETFs or bear ETFs.
Why buy an inverse ETF? There are several reasons why you should consider investing in inverse ETFs.
The key benefit of inverse ETFs is that they allow you to make money when the market goes down. This makes them a useful hedge against market downturns, allowing you to counteract your losses from other investments when stock prices fall.
Inverse ETFs allow you to bet against the market like you would when short-selling stocks. But unlike with shorting a stock, you don’t need to borrow any shares.
Shorting stocks is an advanced and risky trading strategy that involves borrowing shares from a broker and selling the stocks immediately. The rationale here is that if the stock price falls sharply as you predict, you can buy them back at much cheaper prices and return them to your broker while keeping the difference.
But when you invest in an inverse ETF, you invest with your own money.
Inverse ETFs can also be held in registered accounts, such as a TFSA or RRSP. This allows you to make the most of tax advantages that apply to your investment income.
You can invest in inverse ETFs across an extensive range of assets and market sectors, not just the S&P 500. It’s easy to access inverse ETFs for a host of major stock market indices as well as bonds, commodities and cryptocurrencies.
While they have their advantages, there are also several risks you should consider before investing in inverse ETFs.
There’s no guarantee that the market will move the way you predict. So if you invest in an S&P 500 inverse ETF and the S&P 500 goes up, you’ll suffer a loss.
Inverse ETFs are rebalanced daily. This means they’re designed for short-term use only, and holding an inverse ETF for longer than one day could cause you to suffer a loss. As a result, they’re better suited to active and experienced traders, and they usually aren’t suitable for casual investors who take a long-term, hands-off approach to investing.
Inverse ETFs are designed to be bought and sold much more often than regular ETFs. You’ll need to pay brokerage fees when you place a buy or sell order, so make sure you factor this additional cost into your calculations.
Inverse ETFs have higher management fees than regular ETFs because they’re actively managed and rebalanced daily. For example, while some index ETFs track Canadian stocks and have management expense ratios of less than 0.1%, it’s common for inverse ETFs to have management fees of 1% or more.
Your losses can be even greater if you invest in leveraged ETFs because these are designed to magnify the daily performance of a given index. That means investors can expect higher rewards but also bigger losses.
Consider the following factors when comparing inverse ETFs:
To invest using inverse ETFs you must first have a discount brokerage account. Then, it’s time to consider the options. To get started here are 10 of the best-known inverse ETFs in Canada.
This ETF is designed to move in the opposite direction of the Nasdaq-100 Index. It offers 3X daily short leverage on nonfinancial equities like US Treasury Bills, so this ETF is best for investors with a high risk tolerance who aren’t looking to hold onto stocks for the long run.
Buy on Interactive BrokersDesigned to perform in the opposite direction of the S&P 500, this ETF can be useful during bear markets. Results are delivered over a single trading session, with exposure resetting every month. The ProShares Short S&P500 might be suitable for investors who want to bet against large-cap US equities and who don’t plan to hold their stocks in the long run.Buy on Interactive Brokers
This ETF tracks the 100 largest nonfinancial securities on the Nasdaq. Results are delivered over a single trading session, with exposure resetting every month. The PSQ may be suitable for short-term investors who want to hedge against their Nasdaq investments or bet against top Nasdaq nonfinancial stocks.Buy on Interactive Brokers
This ETF is designed to move in the opposite direction of the S&P 500 Index. It offers 2X daily short leverage on large-cap US equities like US Treasury Bills. Leverage resets every day. This ETF is best for investors with a high risk tolerance who aren’t looking to hold onto stocks for the long run.Buy on Interactive Brokers
This ETF is designed to move in the opposite direction of the S&P 500 Index. It offers 3X daily short leverage on large-cap equities. Leverage resets every day. This ETF is best for investors with a high risk tolerance who aren’t looking to hold onto stocks for the long run.Buy on Interactive Brokers
This ETF is designed to generate performance opposite to the S&P 500, which contains some of the biggest blue-chip companies in America. Investors could use this ETF to hedge against existing S&P 500 investments or bet against large-cap, blue-chip companies in the US.Buy on Interactive Brokers
This ETF is designed to move in the opposite direction of the Dow Jones Industrial Average. It offers 3X daily short leverage on large-cap US equities. Leverage resets every day. This ETF is best for investors with a high risk tolerance who aren’t looking to hold onto stocks for the long run.Buy on Interactive Brokers
This ETF is designed to move in the opposite direction of the Russell 2000 Index. It offers 3X daily short leverage on small-cap equities. Leverage resets every day. This ETF is best for investors with a high risk tolerance who aren’t looking to hold onto stocks for the long run.Buy on Interactive Brokers
This ETF tracks an index of small-cap US equities that are also tracked by the Russell. Results are delivered over a single trading session, with exposure resetting every month. The RWM may be suitable for short-term investors who want to hedge against existing investments or bet against small-cap US stocks.Buy on Interactive Brokers
This ETF aims to move in the opposite direction of an index that invests in American blue chip companies, particularly the Dow Jones Industrial Average. So it may produce strong returns when major American companies in that index experience losses in share price.
However, the index has in recent times been experiencing an overall gain and recently broke records. So, it may be best to monitor this ETF closely before jumping in.Buy on Interactive Brokers
Inverse ETFs can help you profit when the stock market falls or when a particular sector goes down. But inverse ETF investing is complicated, and the losses can be as big as the potential returns, so it’s not a suitable option for all investors. It’s also not suitable as a long-term strategy.
If you want to invest in inverse ETFs, compare investing platforms before you open an account.
Your guide to how ETFs work and whether this type of investment is right for you.
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