Exchange traded funds (ETFs) have taken the investment world by storm, and are a popular alternative to individual stocks and mutual funds for many inventors. And while ETFs have become increasingly popular, their many benefits may have you wondering if ETFs are too good to be true.
One of the common questions that people have about ETFs is whether they are derivatives, which have added risk and speculation. The short answer is no. To understand why, you first need to know how ETFs work, why they’ve become so popular and their relationship to derivatives.
The Short Version
- ETFs are securities that track the performance of underlying assets.
- While ETFs derive their value from the underlying assets, they are not derivatives.
- However, some ETFs use derivatives to achieve their goals, such as leveraged ETFs, inverse ETFs, and commodity ETFs.
What Is an ETF?
An exchange-traded fund is a basket of securities that tracks the performance of its underlying assets.
Some ETFs are actively managed. This means a fund manager chooses each individual investment for the fund and buys and sells assets as they see fit. Others are passively managed, meaning they track the performance of a market index.
ETFs are similar to mutual funds in the diversification they provide, but they have some key differences. As the name suggests, ETFs trade on stock exchanges. Unlike mutual funds, where all transactions settle at the end of the trading day, ETFs trade like stocks throughout the day, giving inventors more control over the sale price.
ETFs come with plenty of benefits for investors. First, they’re easy to trade, just like stocks. Because they trade throughout the day, investors can buy and sell at any time and know what price they’re getting.
ETFs also provide diversification. Rather than having to invest in many different stocks and bonds, inventors can create a diversified portfolio by investing in a single ETF, which is why total market and S&P 500 ETFs have become so popular.
ETFs come in many different forms. Some of the most popular include:
- Market ETFs, which track a particular market index or the entire stock market.
- Bond ETFs, which provide exposure to the total bond market or a portion of it.
- Sector ETFs that hold securities from a particular industry or sector, such as healthcare or technology.
- Commodity ETFs that track a particular commodity, like gold or oil.
- Market cap ETFs, which track either the small-cap, medium-cap, or large-cap market.
Suppose you invested in an ETF that tracked the S&P 500 index. You get the benefit of owning stock in all 500 companies in the index without actually having to buy stock in those 500 companies. Not only do you have diversification, but also simplification.
As we’ll discuss later, ETFs have become an increasingly popular investment vehicle. Many people invest in ETFs instead of individual stocks or mutual funds. Even professionals are turning to ETFs, with 67% of institutional investors investing at least 40% of their portfolio in ETFs in 2021, up from 36% in 2020, according to research from JP Morgan.
What are Derivatives?
A derivative is a complex investment tool whose value comes from another source. It includes a contract between two parties where each agrees to take a certain action under certain circumstances, such as a price change of the underlying asset.
The prices of derivatives are usually based on the fluctuation of the underlying asset. These underlying assets are usually stocks, commodities, bonds, currencies, or even cryptocurrency. Investors use derivatives to hedge against investment risk.
Derivatives can trade on exchanges or over-the-counter and are considered higher-risk investments. Examples of derivatives include futures and options that allow, or require, the two parties to buy or sell a particular asset at a certain price in the future.
For example, let's say there is a futures contract for oil at $70 a barrel in three months when it's currently selling at $65 a barrel. You think the price will go beyond $70 in three months, so you buy the contract in the hopes that in three months the price of oil will be higher and you can sell the oil for a higher price than you bought it for.
Are ETFs Derivatives?
You might find yourself wondering if ETFs are derivatives — after all, they technically derive their value from the underlying assets of a fund. But the short answer is that no, ETFs are not derivatives.
First, a derivative is a contract between two parties where they agree to take a certain action under certain circumstances in the future. For example, a call option gives the contract’s holder the right — but not the obligation — to buy an underlying security in the future at a certain price, called a strike price. The contract holder doesn’t have to buy the security. But if they choose to, then the other party in the contract is obligated to sell.
But in the case of an ETF, the fund already owns the underlying assets. Rather than buying a contract that dictates future transactions, you’re buying a small piece of the assets owned by the fund and can benefit from an increase in those assets’ prices.
So while it’s true that ETFs derive their value from their underlying assets, it’s not quite in the same way as an actual derivative.
ETF Derivative Exceptions
Although ETFs generally aren’t derivatives, there are some exceptions. A select number of ETFs use derivatives to help reach their objectives. Let’s discuss a few types of ETFs that could be considered derivatives:
A leveraged ETF is one that tracks an underlying index or collection of securities, but with amplified returns. Investors of a leveraged ETF may see returns as much as two to three times higher than investors in a traditional ETF that tracks the same index.
So how can a leveraged ETF achieve greater returns than the index it’s tracking? Rather than simply investing in the underlying index or securities, the ETF also purchases derivatives of the index or individual securities. For example, a leveraged ETF of healthcare stocks is likely to own individual healthcare stocks, as well as options contracts and other derivatives with those same stocks as the underlying asset.
You probably won’t be surprised to learn that leveraged ETFs, while they have the potential for higher profits, also have the potential for greater losses. Not only can investors lose money on the stocks themselves, but they can also lose money on their derivatives.
An inverse ETF is a type of ETF that’s actually profitable when the underlying index or securities lose value. In most cases, you invest in a particular stock with the hope that it gains value. But with an inverse ETF, it’s the opposite.
Rather than investing just in the underlying stocks, inverse ETFs invest in derivatives that are profitable when the underlying index does poorly. You’re essentially betting against the index.
Let’s say you think there’s going to be a market correction and want to make money on the decline in stock prices. You might invest in the ProShares Short S&P 500 — a popular inverse ETF that provides a -1X daily return of the S&P 500 itself. In other words, for every gain or loss of the S&P 500, the inverse ETF sees an identical gain or loss in the opposite direction.
It’s important to note that inverse ETFs are best as a short-term investing strategy. In the long term, the S&P 500 has increased in value. If you bet against it in the long-term, you’re likely to be wrong. Instead, inverse ETFs are best for speculating short-term market fluctuations.
A commodity is a physical asset, usually a type of raw material, that can be bought and sold. Popular commodities markets include gold, oil and corn.
While the name suggests otherwise, commodity ETFs don’t always actually purchase the commodities themselves. Instead, they often purchase futures contracts for the underlying commodity. For example, a gold ETF doesn’t invest in gold. Instead, it invests in futures contracts that speculate on the future price of gold.
Commodity ETFs are an easy way for investors to benefit from the price movements of certain commodities without actually having to purchase them. It’s important to note that commodities markets are quite different from stock and bond markets; if you decide to add commodity ETFs to your portfolio, it’s important to do your research first.
Why Are ETFs so Popular Among Investors?
ETFs have become increasingly desirable over the past several decades as an attractive alternative to individual stocks and mutual funds.
ETFs are a popular alternative to individual stocks and bonds because of the diversification they provide. If you have just $50 to invest, you may only be able to invest in one or two companies, and the success of your portfolio will rely on those companies entirely. A drop in the stock price of one of those companies can mean bad news for your portfolio.
But with ETFs, you can create a well-diversified portfolio with that same $50 per month. Rather than investing in just a few companies, you could invest in an S&P 500 ETF and have a portfolio of 500 different companies. And a total market ETF would give you access to thousands of companies.
And while ETFs provide more diversification than individual stocks, they do have some similarities. This makes ETFs a great combination of stocks and mutual funds. After all, they trade through the day like stocks, making them more liquid and giving an investor more control over the sale price. They’re also more tax-efficient and often have low expense ratios. Additionally, while some mutual funds still have minimum investments of thousands of dollars, you can invest in an ETF for just the price of a single share.
All in all, ETF inventors get the best of both worlds of individual stocks and diversified mutual funds.
Are ETFs Too Good to be True?
With the rise in popularity of ETFs, it’s important to stop and ask yourself whether it’s the right investment for you. More companies have begun introducing zero-fee ETFs, which makes you even more likely to ask yourself whether they’re too good to be true.
The short answer is that no, they aren’t too good to be true. ETFs have plenty of legitimate benefits, such as their diversification, low fees and tax efficiencies. Many investors are also attracted to the fact that they trade like stocks rather than like mutual funds.
Although ETFs have plenty of benefits, they also have some downsides that are worth discussing.
First, because ETFs trade throughout the day like stocks, some investors could be tempted to try day trading ETFs. But the reality is that most ETFs are better as a buy-and-hold investment. This is especially if you’re holding them in a retirement account or investing for a long-term goal.
Additionally, just like stocks, some brokers may charge trading fees or commissions on ETFs. Unfortunately, this results in getting hit with multiple fees, since you pay the trading cost to buy the shares and the expense ratio to hold them.
Another downside to ETFs is the potential for a bid-ask spread, which occurs when there’s a difference between what one investor is willing to sell the shares for and what the other is willing to buy them for. The larger the bid-ask spread, the lower the liquidity of the ETF.
While it’s important to be aware of these downsides, know that you’ll find similar disadvantages with other types of investments.
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The Bottom Line
ETFs are a popular investment vehicle thanks to their diversification, low fee, and the way they trade throughout the day on exchanges. Despite some people’s fears, ETFs aren’t inherently derivatives.
That said, some ETFs do invest in derivatives. It’s important to understand the additional risk that comes with investing in those securities. As with any other type of investment, do your own research. Only invest in things you understand and know the risks of.