Are ETFs Derivatives?
The short answer is that 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. They claimed that overly complicated models involving computerization and statistical models led to a skewed view of the financial economy. 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 has led to numerous misconceptions, especially about ETFs, that had recently gained popularity. (For related reading, see: "Did Derivatives Cause the Recession?")
Generally speaking, ETFs are not derivative-based investments. However, there are some exceptions, such as special leveraged ETFs and inverse ETFs.
Generally, ETFs Are Not Derivatives
First off, 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. (For more on derivatives, see: Derivatives 101).
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.
Exceptions: 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.