What Is a Short ETF and How Does It Work?

Exchange Traded Funds, or ETFs, are investment vehicles that trade on stock exchanges, much like individual company shares. These funds typically track the performance of a specific index, commodity, or basket of assets. While many ETFs are designed for market growth, a specialized category known as a short ETF offers a different approach to market exposure. This article explains what a short ETF is and how it functions.

Understanding ETFs and Short Selling

Exchange Traded Funds are investment funds that hold a collection of securities, such as stocks, bonds, or other assets. These funds trade on public stock exchanges throughout the day, allowing investors to buy and sell shares at market prices, similar to individual stocks. ETFs offer investors diversified exposure to various market segments or asset classes in a single investment.

Short selling is an investment strategy for those who anticipate a decline in an asset’s price. This process involves borrowing shares of a security, selling them, and then repurchasing the same number of shares at a lower price to return to the lender. Profit comes from the difference between the initial higher selling price and the subsequent lower repurchase price. This strategy differs from traditional investing, where an asset is bought expecting its price to increase.

Defining a Short ETF

A short ETF, also called an inverse ETF or a bear ETF, is an investment product structured to deliver the opposite performance of an underlying index or benchmark. Its objective is to generate a positive return when the value of the tracked index or asset declines. For instance, if the S&P 500 index falls by 1% on a given day, a corresponding short ETF aims to increase in value by 1% that same day.

This inverse relationship distinguishes short ETFs from traditional ETFs, which track the upward movement of an index. Short ETFs provide investors a mechanism to profit from or hedge against market downturns without direct short selling of individual securities. Unlike direct short selling, where losses can be unlimited if the asset’s price rises significantly, the maximum loss for an investor in a short ETF is limited to the amount initially invested.

How Short ETFs Operate

Short ETFs achieve their inverse objective without directly shorting individual securities within their benchmark index. Instead, these funds utilize financial derivatives, such as futures contracts, options, and swap agreements, to gain inverse exposure. These instruments are agreements to buy or sell an asset at a predetermined price on a future date, allowing the fund to bet on the asset’s price direction.

The value of these derivative positions moves inversely to the underlying index. If the benchmark index decreases, the derivatives held by the short ETF are structured to increase in value, boosting the ETF’s net asset value. This requires active management by the fund’s advisors, who adjust the derivative portfolio to maintain the desired inverse correlation.

A key feature of short ETFs is “daily rebalancing.” The fund adjusts its holdings daily to align its exposure with its stated inverse objective. This daily reset ensures the fund consistently aims for the inverse return of its benchmark, resetting its position regardless of previous market movements. Rebalancing involves buying or selling derivative contracts to maintain the fund’s target inverse exposure.

Key Characteristics of Short ETFs

A key characteristic of short ETFs is the “compounding effect,” often called volatility decay, which impacts performance over periods longer than a single trading day. While these funds provide the inverse return of their benchmark for one day, their returns can diverge from the inverse performance of the underlying index over extended periods. This divergence occurs because daily rebalancing can lead to an erosion of returns, particularly in volatile markets with frequent up-and-down movements. The fund’s need to adjust positions by “buying high and selling low” to maintain daily inverse exposure can diminish overall returns over time, even if the underlying index finishes flat.

Short ETFs are subject to “tracking error.” This is the difference between the ETF’s actual performance and the inverse performance of its underlying benchmark. Factors contributing to tracking error include operational costs, frequent rebalancing trading fees, and market conditions like liquidity constraints or bid-ask spreads. While managers strive to minimize this deviation, perfect inverse correlation is challenging to achieve consistently.

Short ETFs have higher expense ratios compared to traditional, passively managed ETFs. This increased cost, ranging from approximately 0.8% to over 1% annually, is due to the complexity of managing derivative positions, the higher frequency of trading for daily rebalancing, and the expertise needed to operate these funds. These fees are subtracted from the fund’s assets and can impact returns, especially when held for longer durations.