Not all exchange traded funds (ETFs) deal exclusively in stocks and bonds. Many make use of derivatives to get exposure to a corner of the market, as well. Here’s how to tell if your ETF is using them.
Derivatives are securities that derive their value from something else, according to iStockAnalyst. When you buy a stock, you’re getting a share of ownership of that company. If you buy an option on that same stock, you’re not buying a share in the company. Instead, you’re buying a derivative. [Active ETF Providers Drop Derivatives.]
ETFs make use of derivatives for various reasons. For instance, inverse ETFs often use derivatives instead of short selling stocks on an index. Leveraged ETFs would utilize swaps and/or futures to provide the double or triple daily return of an index. Commodity-based ETFs may trade in futures contracts instead of actually trading the physical commodity for cash. [Why the SEC Has Taken Aim at Derivative ETFs.]
iStockAnalyst compiled a helpful list of what types of ETFs own derivatives and which type primarily own the underlying security. Call the ETF provider or look at the prospectus on our ETF Resume to see what the actual holdings are. These are general guidelines, not hard-and-fast rues.
- ETFs that are non-leveraged and non-inverse usually own underlying securities of an index.
- Inverse ETFs usually hold derivatives like swaps and futures.
- Leveraged ETFs also hold a majority of assets in swaps and futures.
- Physically-backed commodity funds own the commodity they track.
- Non-physically-backed ETFs usually track futures.
- Exchange traded notes (ETNs) do not buy anything but are subject to credit risk of the issuing bank, which frequently hedge positions with derivatives.
ETFs that own derivatives are not bad. In fact, they can be very beneficial if understood and used with care.
For more information on ETFs, visit our ETF 101 category.
Max Chen contributed to this article.
The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.