Most exchange-traded funds (ETFs) are not considered to be derivatives. In the aftermath of the 2008 financial crisis, many pundits blamed derivatives and financial engineering for the market collapse. As a result, many investors have shied away from derivative-based securities and other new financial products to avoid the risks associated with them. Unfortunately, this risk aversion led to numerous misconceptions, especially about ETFs that had recently gained popularity.

ETFs Are Not Derivatives, Unless They Are

A derivative is a special type of financial security – its value is based upon that of another asset. For example, stock options are a derivative security because their value is based on the share price of a publicly traded company, such as General Electric. 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.

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.

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 should be considered a derivative because the assets in its portfolio are themselves derivative securities.

(For related reading, see "Did Derivatives Cause the Recession?")