Are ETFs Derivatives?

Exchange-traded funds (ETFs) are not derivatives. They are pools of money used to buy, hold, and sell a selection of stocks, bonds, or other assets. Their investments do not generally include derivatives. Some specialized ETFs use derivatives like options or futures contracts for specific purposes, such as hedging.

Understanding ETFs

ETFs are investment funds that can be bought and sold on stock exchanges. They offer investors a diversified portfolio of assets, such as stocks, bonds, or commodities. Instead of buying the stocks of 20 or 500 companies, an individual investor can buy one fund that owns all of those stocks. ETFs are designed to track the performance of a specific index, commodity, or basket of assets. The ETF manager is replicating the contents of the index, not deciding which stocks to buy and when to sell them. That makes ETFs passively invested funds, not actively invested funds. A key feature of ETFs is their intraday trading capability. Investors can buy or sell shares throughout the trading day at market prices. This is the big distinguishing factor between an ETF and an index mutual fund, which is bought from the company that manages it and must be sold back to it. So, ETFs combine elements of mutual funds and individual stocks, offering the diversification of mutual funds while trading like stocks. They are known for their liquidity. The most popular ETFs trade frequently, so it's easy to buy and sell your ETF shares.

Understanding Derivatives

A derivative is a financial product whose value is based upon that of another asset. For example, stock options are derivative securities because their value is based on the share price of a publicly traded company, such as General Electric (GE).

Options provide their owners with the right, but not the obligation, to purchase or sell shares of a stock at a specific price by a specific date. The investor makes or loses money on the difference between the options price and the actual price on that date. The value of an option, therefore, is derived from a stock's share price but does not reflect actual ownership of those shares. Other types of derivatives include futures, forwards, and swaps. Equity-based ETFs are similar to mutual funds in that they own shares outright for the benefit of fund shareholders. An investor who purchases shares of an ETF is purchasing a security that is backed by the actual assets specified by the fund’s charter, not by contracts based on those assets. This distinction ensures that ETFs neither act like nor are classified as derivatives.

Derivative-Based ETFs

While ETFs are not derivatives and most do not invest in derivatives. A few relative newcomers to the ETF landscape are derivative-based. That is, they invest in derivatives.

Leveraged ETFs aim to provide returns that are a multiple of the underlying index. For example, the ProShares Ultra S&P 500 ETF seeks to provide investors with returns that equal twice the performance of the S&P 500 index. If the S&P 500 index rises 1% during a trading day, shares of the ProShares Ultra S&P 500 ETF would be expected to climb 2%.

This type of ETF can be considered a derivative-based ETF because the assets in its portfolio are themselves derivative securities.

Inverse ETFs

Inverse ETFs are another category of derivative-based ETFs. It may sound counterintuitive to invest in a low-performing fund, but many active and short-term investors choose to buy inverse ETFs if, for example, they are anticipating a period of low growth in a particular industry or the economy as a whole.

The ProShares Short S&P 500 ETF is an example of an inverse ETF. Investors who have a negative outlook on the S&P 500 would make money in this fund if the S&P 500 Index drops. Other traditional funds would fall in value during the same period.

ETFs and Hedging

ETFs may also incorporate derivatives for hedging as a strategic approach to risk management within their portfolios. This means the ETF uses financial instruments such as futures or options contracts to hedge risk.

The primary objective is to safeguard the ETF from potential adverse movements in the financial markets. In essence, derivatives provide a means for ETF managers to establish positions that act as a counterbalance to the fluctuations in the underlying assets held by the fund. This may sacrifice potential upside returns, but it (in theory) protects the value of the fund. Let's walk through an example. Suppose an ETF tracks a stock index, and the manager anticipates a potential downturn in the market. In this scenario, the manager might employ index futures or options contracts to offset potential losses in the ETF's stock holdings. These offsets can be held within the ETF or outside of the fund, but the goal is to counterbalance the potential downside of the assets. If the market indeed experiences a decline, the gains from the derivatives can help neutralize or mitigate the impact on the overall value of the ETF portfolio. If the market does not experience a decline, the ETF will enjoy positive returns due to market conditions. Even though the hedged position is now worthless, it can be seen as an unused insurance policy that was simply not needed.

ETFs and Commodities

Commodity ETFs allow investors to profit from the trade in commodities without actually buying or selling that commodity. In that sense, these are derivative-based ETFs. This variation on derivatives is an essential component of commodities trading. A commodities trader does not buy bushels of corn or barrels of oil and then try to sell them at a profit. The trader buys a bunch of contracts that represent the future ownership of these commodities at pre-determined prices. The latter option is also much more feasible when assembling an ETF. Though the ETF itself may not actually own the physical commodities, it owns financial products that can be exchanged for those commodities.

The Bottom Line

ETFs are investment funds that trade on stock exchanges, offering investors diversified exposure to various assets like stocks, bonds, or commodities. Derivatives, such as futures or options contracts, are financial instruments that derive their value from an underlying asset. Some ETFs incorporate derivatives within their portfolios, though an ETF by itself is not a derivative.