EARLIER this week, Deutsche Bank launched the first European-listed exchange-traded fund (ETF) that tracks the inverse daily performance of an Asian stock market – Hong Kong’s Hang Seng. The investment bank’s ETF division, DB X-trackers, also announced that it has launched four new European sector ETFs on short daily indices, bringing the number of the provider’s short ETFs listed on the London Stock Exchange (LSE) to 15. <br /><br />The growing number of short, or inverse, ETFs on offer reflects the growing popularity among investors. At DB X-trackers, which accounts for about 60 per cent of the European short ETF market, assets under management on short daily indices now exceed €2bn and are among the most actively traded ETFs in Europe, according to Manooj Mistry, head of DB X-trackers UK.<br /><br />While inverse ETFs still account for only a very small proportion of European ETFs – 2.2 per cent of total assets under management in Europe as of the end of the third quarter – across the Atlantic, where the ETF market is much more mature, flows into inverse exchange-traded products (ETPs) were $1.7bn in September alone in the United States. <br /><br />So how exactly do these inverse ETFs work? In the same way that a long ETF is designed to track the performance of the underlying asset, inverse ETFs are designed to mirror the opposite performance of the index, so if the FTSE 100 were to fall 2 per cent then the short FTSE 100 ETF would rise 2 per cent. These products were designed to give investors, who found it difficult to go short on an index using derivatives or by borrowing shares, the ability to act on any bearish views. <br /><br /><strong>SQUEEZE HIGHER</strong><br /><br />Inverse ETFs allow you to profit from a falling market without actually needing to go short in the strict sense. You are buying the ETF, so you do not need to borrow shares on margin from your broker. You also avoid the costs associated with selling short as well as the risks that can occur when short positions unwind and the market is squeezed higher.<br /><br />Where inverse ETFs fundamentally differ from their long ETF counterparts is in their payoff structure. Most leveraged and inverse ETFs reset on a daily basis, meaning that they are designed to achieve their stated objectives of tracking the inverse performance of the underlying index over the day. However, due to the effect of compounding, the performance of inverse ETFs over longer periods of time can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same time period. <br /><br />They work best for you, says Scott Thompson, co-head of European sales at ETF Securities, when the market is moving in the same direction for a couple of days. If you are holding your positions, then a trending market allows you to benefit from compounding. When the market is falling, the inverse ETF is compounding in your favour and when the market is rising, it is de-compounding in your favour.<br /><br />For example, investors have started to become less confident in a continually rising market, says Thompson, who adds that ETF Securities has seen clients start entering its short FTSE 100 ETF over the past week or so. And ETF Securities’ super-short ETF offers double the percentage change on the underlying index – ideal for investors looking to leverage their short positions. <br /><br /><strong>CHOPPIER MARKETS</strong><br /><br />Beware though, that in volatile conditions, the inverse ETF will no longer work in your favour because compounding becomes a problem. For example if you invested £100 in an inverse ETF on the FTSE 100 and the benchmark lost 10 per cent on the first day, then your position would have gained 10 per cent and would be worth £110. However, if the FTSE 100 were then to rise 10 per cent on the second day, the inverse ETF would have lost 10 per cent, taking your overall position down to £99, which is less than you put in in the first place. <br /><br />In choppier markets, you may want to nip in and out of short ETFs on a daily basis to profit from the falling market without risking any negative effects of compounding. <br /><br />Therefore, if you are looking to hold your inverse ETF over several days or even weeks – perhaps to hedge your long positions on the same underlying asset – then you would need to monitor your position and your returns very carefully to ensure your profit is what you expect it to be. <br /><br />DB X-trackers’ Manooj Mistry agrees, saying that short ETFs are very much a short-term tactical investment tool, especially in volatile market conditions. Providing investors understand the pitfalls of compounding, then short ETFs can be ideal for bearish investors expecting a falling market.