Are ETFs Derivatives?
The short answer is that most exchange-traded funds (ETFs) are not considered to be derivatives. They are investment funds that hold a diversified portfolio of assets, such as stocks or bonds. However, some ETFs may use derivatives within their portfolios for various purposes, such as hedging or achieving specific investment objectives.
Key Takeaways
- Most ETFs are not derivatives; they are investment funds with diversified portfolios.
- ETFs trade on stock exchanges, providing efficient access to various assets.
- Some leveraged and inverse ETFs are considered derivative-based. These ETFs use derivative securities like options or futures contracts.
- ETFs may use derivatives for hedging to offset potential losses and manage risk.
Understanding ETFs
ETF are investment funds that are traded on stock exchanges. This gives people a way to buy and sell a diversified portfolio of assets, such as stocks, bonds, or commodities. However, instead of having to own a range of assets, you can simply own one ETF that is a fund of a range of assets.
ETFs are designed to track the performance of a specific index, commodity, or basket of assets. This means the ETF manager is trying to replicate what an index does, not necessarily beat it. One key feature of ETFs is their intraday trading capability, allowing investors to buy or sell shares throughout the trading day at market prices.
ETFs combine elements of both mutual funds and individual stocks, offering diversification like mutual funds while being traded on exchanges like stocks. They are known for their liquidity, as a lot of people trade ETFs so it’s easy to buy and sell your ETF shares. However, the specific liquidity of an ETF depends on the volume of that specific fund, and specific ETFs may be more difficult to buy or sell at market price.
Understanding Derivatives
It’s important to understand the definition of a derivative. A derivative is a special type of financial security 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).
These options provide their owners with the right, but not the obligation, to purchase or sell GE shares at a specific price by a specific date. The values of these options, therefore, are derived from the prevailing GE share price, but they do not involve an actual purchase of those shares. Other kinds of derivatives include futures, forwards, options, or 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.
Generally speaking, ETFs are not derivative-based investments. However, there are some exceptions, such as special leveraged ETFs and inverse ETFs.
Derivative-Based ETFs
While ETFs are generally not considered derivatives, there are exceptions. Recent history has seen the rise of numerous leveraged ETFs seeking 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 rose 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 are also another category of derivative-based ETFs, which reflect the opposite of the anchor asset or fund. While this may sound counterintuitive to invest in a low-performing fund, many active and short-term investors choose to buy inverse ETFs if, for example, they are expecting an upcoming season or period of low growth. 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 reap an investment benefit from this fund if the stock market does drop, uniquely enough, while other traditional funds may fall in value.
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
ETFs, derivatives, and commodities intersect in the financial landscape, with commodity ETFs serving as a notable example of this convergence. Commodity ETFs enable investors to gain exposure to the price movements of physical commodities or commodity futures contracts without having to actually buy or sell that commodity.
ETFs are structured to hold either the actual commodities or derivatives, such as futures contracts, tied to the commodities they track. The use of derivatives in commodity ETFs is particularly prevalent, offering flexibility and efficiency in gaining commodity exposure without the necessity of holding the physical assets.
Think about how a portfolio manager assembles their ETF. They could go out and buy a bunch of commodities. Instead, they could also buy a bunch of contracts that represent the future ownership of commodities at specific prices. The latter option is 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.
Can ETFs Hold Derivatives in Their Portfolios?
Yes, ETFs can hold derivatives such as futures or options contracts in their portfolios. These derivatives serve various purposes, including hedging against risks, optimizing portfolios, and providing leverage or inverse exposure. Note that ETFs and derivatives are not the same thing, though.
What Role Do Derivatives Play in ETFs?
Derivatives in ETFs play roles such as hedging, optimizing portfolios, and providing leverage or inverse exposure. ETFs, by themselves, can be pretty straightforward acting as a fund that holds a bunch of different stocks or bonds. Derivatives can enhance what the ETF does.
How Do Commodity ETFs Utilize Derivatives?
Commodity ETFs use derivatives like futures contracts to gain exposure to commodities such as gold or oil. These derivatives help track the price movements of the underlying commodities without having to actually own the commodity.
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.