Best of the Week
Most Popular
1. Investing in a Bubble Mania Stock Market Trending Towards Financial Crisis 2.0 CRASH! - 9th Sep 21
2.Tech Stocks Bubble Valuations 2000 vs 2021 - 25th Sep 21
3.Stock Market FOMO Going into Crash Season - 8th Oct 21
4.Stock Market FOMO Hits September Brick Wall - Evergrande China's Lehman's Moment - 22nd Sep 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.How to Protect Your Self From a Stock Market CRASH / Bear Market? - 14th Oct 21
7.AI Stocks Portfolio Buying and Selling Levels Going Into Market Correction - 11th Oct 21
8.Why Silver Price Could Crash by 20%! - 5th Oct 21
9.Powell: Inflation Might Not Be Transitory, After All - 3rd Oct 21
10.Global Stock Markets Topped 60 Days Before the US Stocks Peaked - 23rd Sep 21
Last 7 days
Chinese Tech Stocks CCP Paranoia and Best AI Tech Stocks ETF - 26th Oct 21
Food Prices & Farm Inputs Getting Hard to Stomach - 26th Oct 21
Has Zillow’s Collapse Signaled A Warning For The Capital Markets? - 26th Oct 21
Dave Antrobus Welcomes Caribou to Award-Winning Group Inc & Co - 26th Oct 21
Stock Market New Intermediate uptrend - 26th Oct 21
Investing in Crypto Currencies With Both Eyes WIDE OPEN! - 25th Oct 21
Is Bitcoin a Better Inflation Hedge Than Gold? - 25th Oct 21
S&P 500 Stirs the Gold Pot - 25th Oct 21
Stock Market Against Bond Market Odds - 25th Oct 21
Inflation Consequences for the Stock Market, FED Balance Sheet - 24th Oct 21
To Be or Not to Be: How the Evergrande Crisis Can Affect Gold Price - 24th Oct 21
During a Market Mania, "no prudent professional is perceived to add value" - 24th Oct 21
Stock Market S&P500 Rallies Above $4400 – May Attempt To Advance To $4750~$4800 - 24th Oct 21
Inflation and the Crazy Crypto Markets - 23rd Oct 21
Easy PC Upgrades with Motherboard Combos - Overclockers UK Unboxing - MB, Memory and Ryzen 5600x CPU - 23rd Oct 21
Gold Mining Stocks Q3 2021 - 23rd Oct 21
Gold calmly continues cobbling its Handle, Miners lay in wait - 23rd Oct 21
US Economy Has Been in an Economic Depression Since 2008 - 22nd Oct 21
Extreme Ratios Point to Gold and Silver Price Readjustments - 22nd Oct 21
Bitcoin $100K or Ethereum $10K—which happens first? - 22nd Oct 21
This Isn’t Sci-Fi: How AI Is About To Disrupt This $11 Trillion Industry - 22nd Oct 21
Ravencoin RVN About to EXPLODE to NEW HIGHS! Last Chance to Buy Before it goes to the MOON! - 21st Oct 21
Stock Market Animal Spirits Returning - 21st Oct 21
Inflation Advances, and So Does Gold — Except That It Doesn’t - 21st Oct 21
Why A.I. Is About To Trigger The Next Great Medical Breakthrough - 21st Oct 21
Gold Price Slowly Going Nowhere - 20th Oct 21
Shocking Numbers Show Government Crowding Out Real Economy - 20th Oct 21
Crude Oil Is in the Fast Lane, But Where Is It Going? - 20th Oct 21
3 Tech Stocks That Could Change The World - 20th Oct 21
Best AI Tech Stocks ETF and Investment Trusts - 19th Oct 21
Gold Mining Stocks: Will Investors Dump the Laggards? - 19th Oct 21
The Most Exciting Medical Breakthrough Of The Decade? - 19th Oct 21
Prices Rising as New Dangers Point to Hard Assets - 19th Oct 21
It’s not just Copper; GYX indicated cyclical the whole time - 19th Oct 21
Chinese Tech Stocks CCP Paranoia, VIES - Variable Interest Entities - 19th Oct 21
Inflation Peaked Again, Right? - 19th Oct 21
Gold Stocks Bouncing Hard - 19th Oct 21
Stock Market New Intermediate Bottom Forming? - 19th Oct 21
Beware, Gold Bulls — That’s the Beginning of the End - 18th Oct 21
Gold Price Flag Suggests A Big Rally May Start Soon - 18th Oct 21
Inflation Or Deflation – End Result Is Still Depression - 18th Oct 21
A.I. Breakthrough Could Disrupt the $11 Trillion Medical Sector - 18th Oct 21
US Economy and Stock Market Addicted to Deficit Spending - 17th Oct 21
The Gold Price And Inflation - 17th Oct 21
Went Long the Crude Oil? Beware of the Headwinds Ahead… - 17th Oct 21
Watch These Next-gen Cloud Computing Stocks - 17th Oct 21
Overclockers UK Custom Built PC 1 YEAR Use Review Verdict - Does it Still Work? - 16th Oct 21
Altonville Mine Tours Maze at Alton Towers Scarefest 2021 - 16th Oct 21

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

Investors Alert, Does Your ETF Own Derivatives?

Companies / Exchange Traded Funds Dec 02, 2010 - 07:57 AM GMT

By: Ron_Rowland


Best Financial Markets Analysis ArticleWhat’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.
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.
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.
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,


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 and follow the on-screen instructions. Access is free and no registration is required.

This investment news is brought to you by Money and Markets. Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit

© 2005-2019 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.

Post Comment

Only logged in users are allowed to post comments. Register/ Log in