derivative based etfs

Derivative Based ETFs Can Be Very Risky

Exchange traded funds (ETFs) are a popular and useful investment tool for many investors. They allow you to gain exposure to entire markets, industries, or sectors, in an efficient manner. This helps with portfolio diversification, which also can reduce overall portfolio risk. But derivative based ETFs are another story.

There are many types of ETFs out there. And if you don’t understand what they own and how they operate, you can get hurt financially. Of particular concern are derivative based ETFs. These are ETFs that hold primarily derivatives in their portfolios instead of actual stocks, bonds, or commodities, for example.

Derivatives

A financial derivative is an instrument which derives its value from another underlying asset or index. Common types of derivatives include options, futures, forwards, and swap contracts. When entering into derivative contracts such as futures or swaps for example, you typically must have a certain amount of collateral in your account to protect the party on the other side of the contract.

As such, most of these derivative based ETFs generally use U.S. Treasury Bills and other cash equivalents for this purpose.

Futures and swaps are the most common derivative types used in derivative based ETFs, but others are used as well. Although some equity and bond ETFs may use derivatives, they are mostly used in commodity, currency, inverse, and leveraged ETFs.

Now let’s take a brief look at some of the major types of ETFs available in the markets today.

Equity ETFs

The purpose of equity ETFs is typically to track a benchmark equity index. For example, the popular SPDR S&P 500 ETF (SPY) was created to allow investors to easily gain exposure to the S&P 500 Index. As such, this ETF’s holdings consist of shares of common stock of companies which are members of the S&P 500 index.

Bond ETFs

Fixed income or bond ETFs generally track a bond index. For example, the iShares Core U.S. Aggregate Bond ETF (AGG) allows investors to gain easy exposure to the Bloomberg Barclays US Aggregate Bond Index. A bond ETF will primarily hold a portfolio of bonds which are also part of its benchmark index.

Commodity ETFs

Commodity ETFs seek to track commodities such as crude oil, gold, livestock, grains such as wheat or soybeans, etc.

For example, the United States Oil Fund LP (USO) seeks to track the daily price movements of West Texas Intermediate (WTI) crude oil. As such, its benchmark is the near month WTI crude oil futures contract traded on the New York Mercantile Exchange (NYMEX). USO maintains a portfolio primarily consisting of these futures contracts.

The PowerShares DB Commodity Tracking Index Fund (DBC) uses the DBIQ Optimum Yield Diversified Commodity Index Excess Return as its benchmark. This is an index which uses futures contracts to track 14 different commodities. Sectors represented include energy, precious metals, industrial metals, and agriculture. DBC’s portfolio is therefore mostly made up of the underlying commodity futures contracts.

The SPDR Gold Shares (GLD) ETF allows investors to gain exposure to the gold bullion market. It’s benchmark is the spot price of gold bullion. Unlike many commodity ETFs, GLD actually owns the physical underlying commodity which it tracks.

Currency ETFs

As the name implies, these ETFs look to track currencies. For example, the Powershares DB US Dollar Index Bullish Fund (UUP) uses the Deutsche Bank Long USD Currency Portfolio Index – Excess Return as its benchmark.

This index essentially tracks the value of the U.S. dollar relative to six major currencies. As such the fund primarily invests in index futures. These futures contracts are designed to replicate being long the US dollar against the basket of six world currencies.

Inverse ETFs

These ETFs move in the opposite direction of a particular sector or index. For example, the ProShares Short S&P 500 (SH) ETF seeks to return the opposite return of the S&P 500 Index for a single day. This ETF primarily holds S&P 500 Index swap contracts.

Leveraged ETFs

When ETFs are leveraged, they seek to track the returns of an asset or index in a magnified way (usually double or triple). There are leveraged ETFs that track the same direction of a benchmark index (long) or the opposite (inverse).

One example is the ProShares UltraShort S&P 500 (SDS) ETF. This is a leveraged inverse ETF. It seeks to return double the opposite return of the S&P 500 Index for a single day. Its primary holdings are S&P 500 Index swap contracts entered into with various large financial institutions.

Another example is the Direxion Daily Small Cap Bull 3X Shares (TNA) ETF. This ETF seeks to return three times the daily return of its benchmark, the Russell 2000 Index. This index also primarily holds swap contracts on its benchmark index.

Derivative Based ETFs Can Be Dangerous for Long-Term Investors

There are several reasons why derivative based ETFs can underperform, sometimes significantly, if held long-term. Sometimes even a few days can cause material departure from their intended objective. They may even end up going in the opposite direction from that originally expected.

These types of ETFs are usually designed to track their specified benchmark as stated for a single day holding period. Let’s examine why holding for longer time periods may cause problems.

Contango Can Be Problematic for Derivative Based ETFs That Primarily Own Futures

Contango is when the futures contract price of an asset is greater than the spot (current) price of that same asset. The farther out you go into the future, the greater the price. Backwardation is the opposite of contango. It’s a situation where the futures contract price of an asset is less than the spot price of the asset.

Between the two scenarios, contango is typically more common in the futures markets. The closer a futures contract is to expiration, the closer it is to the spot price of the underlying asset. When you have contango, the farther away a contract is from expiration, the higher it is from the spot price.

So when an ETF sells expiring contracts to “roll” into the next near month, it often generates losses. This is referred to as a “negative roll yield.” This occurs because it is selling the cheaper expiring contracts, and buying the more expensive ones which expire farther into the future.

Due to the losses, the ETF is then limited to purchasing fewer and fewer contracts as this process repeats. So besides the losses, the end result is a portfolio of fewer contracts, and a decreasing exposure to the underlying asset.

Example of The Problem of Contango With The USO ETF

We can see a recent example of this when looking at the spot price of WTI crude oil, and the price of the USO ETF over the past few years. The ETF has decreased substantially more than the spot price of oil in recent years. A primary reason for this discrepancy is contango.

As oil prices fell, the USO ETF fell in price as well. But the effect of contango created more losses for the ETF. On top of that, because the ETF was getting less and less exposure to the price of oil, any rebounds along the way in the spot price of crude oil were not fully reflected in the price of the USO ETF.

Fees and Trading Costs Incurred In Managing Derivative Based ETFs Add Up Over Time

ETFs that use derivatives to meet their objectives must be regularly rebalanced. Derivative contracts must also be replaced or rolled forward before expiration. This active management results in fees and trading costs which are generally higher than other ETFs. These costs can add up over time. This can play a significant role in causing the ETF to deviate negatively and significantly from its benchmark index in the long term.

Leveraged ETFs are also relatively more volatile. As such, they typically have higher bid-ask spreads. This spread can add a significant cost to your overall investment transaction.

Compounding Can Be A Major Problem for Inverse and Leveraged ETFs

The way compounding works is that returns are computed based on a cumulative balance, which includes prior returns. For example, let’s say you make 10% on $100 and increase your investment account balance to $110. If you then earn 10% on $110 (instead of $100), you earn $11 (instead of $10), for a total balance of $121.

But when you have a loss, it is also compounded. For example, let’s say you lost 10% on $100 and now have $90. If you gain 10% the next day, you only have $99. You don’t get back to even because the 10% was earned on the reduced balance of $90. Do this a few more times, and you can see how decay in account value can occur in a volatile market.

Inverse And Leveraged ETFs May Do Well Over Longer Time Periods In Trending Markets

Let’s start off with how leveraged ETFs may potentially work in your favor. This scenario primarily occurs when markets generally trend in one direction consistently over time without much volatility.

Let’s say the benchmark index starts at $1,000 and gains 10% to $1,100. Your long 3x ETF, starting at $100 will gain 30% to $130. If the index then gains another 10% to $1,210, your ETF will rise to $169. In this simplified example, the index gained 21%, while the long 3x ETF gained 69%.

So we can see how the effects of compounding are magnified with a leveraged ETF. In reality, however, other issues such as fees and potential negative roll yield would likely temper the excess return.

But Markets Are Likely To Experience Volatility Over Longer Term Holding Periods

There is a good possibility however that the markets will experience volatility. The probability of volatility increasing at some point rises over longer time horizons. As explained earlier, increased volatility can result in problems due to the mathematics of compounding. Let’s look at another example.

Hypothetically speaking, let’s say the benchmark index falls 10% from $1000 to $900. A long 3x leveraged ETF would fall from $100 to $70 or 30%. Now on the next day, assume the index rebounds 10% to $990. The leveraged ETF would rebound 30% ($70 x 1.3) to $91.

After the two days, the benchmark index is down only 1%, while the 3x leveraged ETF is down nine times as much with a loss of 9%. A few more days of this up and down activity and you can see how the value of the ETF can decay. The same scenario plays out with an inverse ETF, but it is more pronounced when there is added leverage as well.

Conclusion

ETFs constructed using derivatives should only be used for very short term trading strategies. They are generally designed in most cases to deliver their target return for a single day holding period. After that, the various factors discussed above create divergence from their stated objectives and benchmarks.

Regardless of holding period, derivative based ETFs are risky types of investments. Only experienced or professional traders should use them.

For long term investments, it is best to use ETFs that own stocks, bonds, or an actual commodity. Also look for ETFs that are liquid (generally have high trading volume) with low expense ratios. The smaller bid/ask spread and lower fees will reduce your trading costs. Compounded over time, this can make a significant difference in your investment portfolio.

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