Does Your ETF Own Derivatives?

What’s in your exchange traded fund (ETF)? The obvious answer is “stocks” if it is a stock ETF, and “bonds” if it is a bond ETF. That’s not always the case, though.

Some ETFs use derivative instruments like futures, options, and swaps. So is there any reason to worry?

Today we’ll explore those questions. I think you may be surprised with the answers.

“Derivative” Isn’t Always a Dirty Word

First, let’s talk about the d-word. A derivative is nothing more than a security that derives its value from something else. When you buy shares of a common stock — we’ll use Microsoft (MSFT) as our example — you are actually getting a piece of ownership in the company.

However, if you buy a call option on Microsoft stock, you aren’t an owner of Microsoft. What you own is the right to become an owner of Microsoft stock at a certain price before a specified deadline. You decide whether to exercise that right.

When you buy a stock, you own a piece of the company.

This may seem like a fine distinction, but legally it’s huge! Microsoft shareholders have many rights. You get to vote on important matters, you get invited to the annual meeting, and you might get a dividend. Option holders receive none of these.

A call option on Microsoft does have some value, though. Its worth is derived from the value of the underlying MSFT shares. Derivatives can reflect the value of a single stock, a bond, an index, a commodity, or even an ETF. Some of these instruments get pretty exotic and are intended mainly for large, institutional investors.

Options, futures, and other derivative instruments can be helpful tools — but like all tools, they can be dangerous if used incorrectly.

Are There Derivatives in Your ETF?

Professional mutual fund managers have been using derivatives for years. Often they will buy or sell index futures to adjust their market exposure quickly. The futures position is then unwound as actual stocks are bought or sold. In most cases, this practice is very routine and carries minimal added risk.

ETFs are usually designed to track an index, like the S&P 500. The easiest way to track an index is to buy the stocks in the index. In the case of the S&P 500, that means you need to own 500 different stocks in various proportions. If you only own 400 of the 500, your results on any given day could vary from the index. And the variance could be quite a lot, depending which stocks are missing from your portfolio.

ETF sponsors know they need to follow their benchmark indexes very closely — but they also need to offer something unique and innovative to attract assets.

You’ve probably heard of inverse ETFs, which are designed to go up as an index goes down. These ETFs can achieve their objective in one of two ways:

• Borrowing shares of stock to sell short, or
• Owning derivatives like swaps and futures.

Most of the time, it’s more economical and convenient for the ETF to buy derivatives. Even ProShares Short S&P 500 (SH), one of the most plain-vanilla inverse ETFs, gets its exposure from derivatives instead of actually shorting the 500 stocks in the S&P.

Inverse and leveraged ETFs rely on derivatives.

Some other ETF categories make heavy use of derivatives as well. Leveraged ETFs are a good example …

Doubling or tripling the daily return of an index may be nice — but making it happen is more complicated than you might think. Leveraged ETFs typically deliver their enhanced results by using swaps and/or futures and should be used with great caution.

Commodity-based ETFs, primarily those that follow precious metals, are backed by physical commodities in storage. SPDR Gold Trust (GLD) is the most popular example of a physically-backed ETF.

But since storage costs are much higher for energy and agricultural goods, ETFs in those segments almost always own futures contracts. PowerShares DB Commodity Index (DBC) is the most popular broad-based commodity ETF, and it invests in futures contracts.

Physically-backed commodity ETFs own real metal.

Then there are the exchange traded notes (ETNs) …

I highlighted the risks of ETNs in a Money and Markets column almost two years ago. Not much has changed since then. When you buy an ETN, you aren’t even getting any derivatives — you are making a loan to the issuer. That means you only have a promise from the issuing bank to pay you some money someday.

My 6-Point ETF Derivatives Guidelines

Here is my quick 6-point reference to help you determine if an ETF invests primarily in the underlying securities or in derivatives. Keep in mind that these are guidelines. Go to the sponsor’s web site and look at the actual holdings to know for sure.

1. ETFs tracking an index in a non-leveraged and non-inverse format typically own the underlying securities of the index, whether they are stocks, bonds, or both.
2. Inverse ETFs typically have the majority of their assets in derivatives (swaps and futures).
3. Leveraged ETFs typically have the majority of their assets in derivatives (swaps and futures).
4. Physically-backed commodity funds own the commodity they are tracking (this group currently includes only precious metals funds as other commodities are too expensive to store).
5. Commodity ETFs that are not physically-backed usually track a futures index and invest in those futures contracts.
6. ETNs do not buy anything. They are bonds that track an equity, commodity, a bond, or other index, and are subject to the credit risk of the issuer. The issuer will often hedge his position with various derivatives.

The Bottom Line …

Am I saying you should avoid all ETFs that contain derivatives? No, not at all. I use them myself in certain circumstances. I’m just telling you to be cautious.

Actually, I am very impressed by the agility with which the ETF industry has met the demand for its products. The trading mechanisms and administrative infrastructure work very well.

I do have one suggestion for ETF sponsors, though …

Can you please find an easier way for the public to identify what a given ETF owns? Right now it requires a trip to each ETF’s web site and sometimes a careful reading of the prospectus. A central online database would be very helpful.

A recent question from a reader provided the inspiration for today’s column.

Mike asked:

“Since most ETFs own derivatives instead of stocks, are they subject to melting down or locking up? In particular, I’d like to know more about ProShares UltraShort 20+ Year Treasury (TBT).”

Mike, TBT is both leveraged and inverse, so based on the guidelines above, my initial assumption would be that it owns derivatives. A visit to its web site confirms this: About 93 percent of the fund is invested in swaps and only 7 percent is short actual Treasury bonds.

Regarding your concern about ETFs not functioning correctly, I don’t think you have anything to worry about in that respect. Yes, there have recently been a few articles and reports about ETFs possibly collapsing from short-selling and ETFs causing systemic risk.

However, I believe these are erroneous. They appear to be written by people who not truly understand how ETFs work, especially the creation/redemption process.

Best wishes,

Ron

P.S. This week on Money and Markets TV, we discuss a topic that’s on people’s minds this holiday season: Technology. Tech devices top many wish lists, and tech stocks are among the hottest buys in the market.

So tune in tonight, December 2, at 7 P.M. Eastern time (4:00 P.M. Pacific). Simply go to www.weissmoneynetwork.com and follow the on-screen instructions. Access is free and no registration is required.