ETFs are designed to behave like an index or a group of securities. That means they move the way the index is moving. Inverse ETFs do pretty much the same thing but instead of a long position, they achieve a short position in those securities. That is the simplistic version of how ETFs work. Much of the inner workings of ETFs remain a mystery to investors, especially when it comes to inverse ETFs.

How does buying an inverse ETF give you short exposure in an index? Do they take your money and give you a short position in all of the components of an index? Or do fund managers pool money from all investors and then take one giant short position in the market?

The answer to the above questions is no. That’s how a mutual fund works (without getting too technical). In the case ETFs, you as an investor are buying ETF shares. The value of those shares goes up or down with the index the ETF is tracking.

The underlying securities that form the index actually come from folks who are called Authorized Participants (basically a market maker or a large institutional investor who has access to large amounts of those securities). When an ETF is initially created, APs provide securities (which they usually borrow from other institutional players) to the fund in exchange for ETF shares. Since that is just a private exchange of one set of securities for another, it’s tax free. APs then sell those ETF shares in the market for retail investors to buy. The ETF shares then take a journey of their own when investors trade them in the open market. The prices of those shares go up and down with supply and demand, the usual way. If the price of the ETF shares deviate from the securities it represents, arbitrage players pick up the lower-valued side (either the ETF shares or the underlying securities) and exchange it for the higher side, making a profit.

Now, the underlying securities against which the ETF shares trade in the market could be actual stocks that form an index or they could be derivative securities like futures or swaps. The ultimate goal is that they should mock the effect of an index: either going with it or against it (in the same proportion or in a leveraged proportion). That effect can be achieved without holding the actual assets (long or short). This is especially true for commodities.

In the above example we learned how inverse ETFs work. Now, let’s see how inverse commodity ETFs work. The idea is to take short positions in commodities so you can gain from price declines. An example of one way to do that is to borrow a ton of copper and then sell it on the open market. Or you could hold a futures contract, giving you the right to sell copper instead. Say you hold a contract to deliver copper at $2.30/lb to a buyer (that you wrote a few months back) and the current spot price is $2.20/lb. You could actually buy the copper at the spot price and sell it to the buyer at the agreed upon price, or it could be cash settled without the delivery of the metal. The end effect is similar to actually holding copper. This is what inverse ETFs use behind the scenes to give you the effect of going long or short on commodities. So as an investor if you buy inverse copper ETFs, the fund is actually holding bearish copper futures. If commodity spot prices fall, the derivative contracts will gain in value, causing ETF shares to go up by the same proportion. Or if the prices rise, the derivative contracts lose value and that will cause the ETF shares to fall by the same proportion as well.

Most individual investors don’t really need to understand the inner workings of ETFs. Knowing that the underlying securities of the ETF are replicating the effect of short selling a commodity is good enough. There are a many good reasons for buying an inverse commodity ETF. For example, you might be bearish about a specific commodity and want to speculate on its future price, or you could be holding some good stocks that are affected by the falling commodity prices and want to hedge against it. Either way, commodities have a low correlation to stocks and therefore are always a good option for diversifying into a new asset class and reducing portfolio risk.

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