Inverse exchange-traded funds aim to profit from a decline in an underlying benchmark’s value by using derivative securities, including swap agreements and forwards. The fund is designed for speculative investors and traders who seek tactical day traders against their respective underlying indices. If you are thinking of investing in inverse ETFs, be wary of the following risks:

Compounding Risk

Inverse ETFs held for longer than a day are affected by compounding returns. The primary goal of an inverse ETF is to generate daily investment results, which are one times the inverse of its underlying index, the fund’s performance may vary from investment objectives that are longer than one day. Investors who desire to hold the fund for more than one day should actively manage and rebalance their positions in order to ease this peril.

In times of high market turbulence, the effect of compounding returns becomes more apparent. Conversely, compounding returns cause an inverse ETF’s performance, for periods longer than a day, to significantly vary from one times the inverse of the underlying index’s return during periods of high volatility.

Correlation Risk

Expenses, high fees, illiquidity, investing methodologies, and transaction costs, among other factors, can lead to correlation risk. As these funds normally rebalance their portfolio on a daily basis, it results to higher expenditures and transaction costs when adjusting. Hence, reconstitution and rebalancing may cause inverse ETFs to be overexposed or underexposed to their benchmarks. As a result, the inverse correlation between an inverse fund and its index may degenerate.

When it comes to inverse ETFs utilizing futures contracts, funds roll their positions into less costly, later futures contracts in times of backwardation. On the other hand, these ETFs roll their positions into more costly, later contracts in contango markets. Hence, it is quite impossible for inverse funds in futures contracts to retain perfectly negative correlations to their underlying indices daily.

Derivative Securities Risk

Several inverse funds render exposure by using derivatives. Such securities, aggressive in nature, expose inverse ETFs to more risks, including credit and liquidity risks. Swaps on indices and ETFs are formed to trail the underlying indexes’ (or securities’) performance. But because of expense ratios and other related factors, the fund’s performance may not perfectly mirror the index’s inverse performance. Normally, inverse funds employing swaps on ETFs carry higher correlation risk and may not attain high correlation degrees with their underlying indices.

Also, inverse ETFs using swap agreements are vulnerable to credit risk. If a counterparty is not willing or cannot fulfill its obligations, the value of swap agreements may plummet substantially. Derivative securities tend to have liquidity risk, and so inverse funds with derivative securities may fail to purchase or sell their holdings on time, or they may not be able to sell their holdings at a rightful price.

Short Sale Exposure Risk

Since inverse funds seek short exposure by using derivatives, these ETFs may be exposed to perils relative to short selling securities. The two dangers of short selling derivatives: increase in the overall volatility level and decrease in the liquidity level. Hence, these two risks may reduce returns from short selling funds.