When investing in stocks, there are two basic strategies for making money. The most common is to take a long position, which means to simply buy a stock and hold it for any length of time before selling it. The second strategy is to take a short position, or to “sell short”. This is done by borrowing and selling a stock, with the hope that its price will go down. An investor will buy back the stock to “cover” his short position at the lower price, and profit from the difference. An inverse fund provides a way to effectively sell short many stocks at one time.
Inverse funds are also called inverse exchange-traded funds (ETFs) because they are traded on a public stock market. An inverse fund is designed to perform as the inverse, or the opposite, of whatever index or benchmark it tracks. For example, an inverse fund that tracks the 30 stocks in the Dow Jones Industrial Average (DJIA), seeks a daily percentage move that is opposite that of the DJIA. If the DJIA moves down by two percent, then the inverse fund that tracks it will move up in value by two percent. Because the value of an inverse fund rises in an environment of declining stock prices, they are popular investments during economic downturns.
Before the advent of inverse funds, if a trader wanted to sell short the stocks of the DJIA, they had to open a margin account with a brokerage house, and sell each of the 30 stocks short individually. However, starting in the late 1990s, inverse funds began to be created and to gain popularity. Inverse funds not only make it easier than ever to sell stocks short in anticipation of a down market, but they also eliminate some of the risk that has traditionally been associated with selling short.
Selling a stock short has the disadvantage of exposing an investor to theoretically unlimited losses, because there is no absolute upper limit to the price of a stock. An inverse fund, on the other hand, is more like taking a long position on a stock, in the sense that it only exposes the investor to the loss of their purchase price. This fact also makes it practical to include an inverse fund as part of a diversified portfolio in order to hedge long positions. Another reason that inverse funds have seen their popularity increase is that they can be included in an Individual Retirement Account (IRA), whereas short positions are not allowed to be held in these accounts.