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We all know these two things:

  • Inverse ETFs bet against a pool of stocks. This might include short selling the stocks and buying puts.

  • Short selling has a limited upside but an unlimited downside.

In the case of an inverse ETF, better yet, a 3x leveraged inverse ETF for which the fund manager is involved in short selling, who bears the risk of stock price appreciation up to or even beyond a margin call?

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    The most you can lose on an inverse ETF is the amount you spent to buy the shares. They are safer than shorting. But some characteristics of the way they are set up makes them lose value over time. Thus they are not recommended for anything but short term bets. – zeta-band Jun 27 '18 at 23:46
  • @zeta-band Thanks for the input, but what about management fees, trading fees, etc. Doesn't that somehow include the cost of borrowing additional funds to meet margin calls? – ToniAz Jun 28 '18 at 0:11
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    Management fees, trading fees, etc. are expenses that lower the return of the leveraged ETF. So while advertised to perform at 2x it might yield 1.9x or 1.7x, etc. If a leveraged ETF reaches the point of violating the margin maintenance requirement, it will liquidate - long before it goes into negative territory. – Bob Baerker Jun 28 '18 at 12:55
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The issuer (not the holders) bears the risk of losses greater than the value of the fund. It is very rare that a stock index (even a narrow one) would rise more than 33% in a day (the rebalancing period) and thus wipe out a 3x inverse ETF. It is important to note that very large stock gains occurring more gradually will not bankrupt an inverse fund, as its continuing losses lead it to scale back its positions daily, but its value will approach zero.

The famous XIV (1x inverse volatility) wipeout came from volatility futures rising nearly 100% in a day. This was an exchange-traded note (ETN, not an ETF), meaning it wasn't even backed by an underlying portfolio but by the issuer's promise to pay according to a formula. The formula allowed the ETN to terminate after this severe loss. Even so, there was a small positive value remaining when it was liquidated.

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