Most exchange-traded funds (ETFs) are not considered to be derivatives. In the aftermath of the 2008 financial crisis, many pundits pointed the finger of blame at derivatives and financial engineering as the primary causes of 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, and 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 that seek 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.

  1. How big is the derivatives market?

    Examine the potential size of the total derivatives market, and learn how different calculations can reduce the estimate ... Read Answer >>
  2. Do ETFs pay capital gains?

    Learn about exchange-traded funds (ETFs), which can generate capital gains for their shareholders due to occasional and substantial ... Read Answer >>
Related Articles
  1. Investing

    A Look At the Growth Of the ETF Industry

    Explore the phenomenal growth rate of the ETF industry, and learn some of the principal reasons why ETFs are projected to continue to grow at a rapid pace.
  2. Investing

    Ultra ETFs Are Not Your Father's ETFs

    Ultra ETFs can add huge returns to your portfolio, but there's a lot of risk and volatility involved with these leveraged ETFs.
  3. Financial Advisor

    SEC Derivatives Rule May Limit Diversification

    The SEC has proposed rules that will limit the use of derivatives by fund managers. Critics believe the rules will impede funds' ability to diversify.
  4. Investing

    The Advantages of ETFs Compared to Index Funds

    With the ongoing ETF boom, ETFs gain more variety and increased competition in the market leads to further investors' advantages compared to index funds.
  5. Investing

    For More And More Investors, ETFs Are A Godsend

    Average and cautious investors can experience lower risk with ETFs - a safer alternative to swaps and derivatives.
  6. Investing

    5 Signs It's Time to Dump Your ETF

    You’ve bought into your favorite ETF, and it's been a great ride. When should you exit? Here are the top signals to exit an ETF position.
  7. Investing

    Top 10 Most Traded Leveraged ETFs (UVXY, SDS)

    Discover how leveraged ETFs work and why they are popular among traders. Learn about the 10 most traded leveraged ETF in the marketplace today.
  8. Investing

    Advantages and Disadvantages of ETFs

    You've probably heard that ETFs are better than mutual funds, but you need to consider all aspects before investing.
  1. Underlying Option Security

    An underlying option security is the financial instrument on ...
  2. Exchange Traded Derivative

    An exchange traded derivative is a derivative that is standardized ...
  3. Underlying Security

    The security on which a derivative derives its value. For example, ...
  4. Derivative Product Company - DPC

    A special-purpose entity created to be a counter-party to financial ...
  5. ETF Futures And Options

    ETF Futures and Options are derivative products built on existing ...
  6. Exchange-Traded Fund (ETF)

    An Exchange-Traded Fund (ETF) is a security that tracks an index, ...
Hot Definitions
  1. Perfect Competition

    Pure or perfect competition is a theoretical market structure in which a number of criteria such as perfect information and ...
  2. Compound Interest

    Compound Interest is interest calculated on the initial principal and also on the accumulated interest of previous periods ...
  3. Income Statement

    A financial statement that measures a company's financial performance over a specific accounting period. Financial performance ...
  4. Leverage Ratio

    A leverage ratio is any one of several financial measurements that look at how much capital comes in the form of debt, or ...
  5. Annuity

    An annuity is a financial product that pays out a fixed stream of payments to an individual, primarily used as an income ...
  6. Restricted Stock Unit - RSU

    A restricted stock unit is a compensation issued by an employer to an employee in the form of company stock.
Trading Center