Many investors see derivatives as inherently dangerous, pointing to the role that derivatives have played in events like the 2008 financial crisis and several other stock market downturns. Even Warren Buffett has pointed out the dangers of derivatives. Yet by themselves, derivatives are just tools, and the risk comes from how any particular investor uses them. Different investors mean different things by the idea of a derivative ETF, but dozens of funds use derivatives prudently to get exposure to certain parts of the market. The following five ETFs make use of derivatives in very different ways, but they each appeal to a certain cross-section of the market.
The key question with derivative ETFs
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The first thing to ask about a derivative ETF is what the underlying asset is that the ETF is trying to track in some way. The reason why derivative ETFs aren't really a category in themselves is that you have to know which derivatives an ETF uses in order to understand its investment objective fully. Simply using derivatives isn't nearly enough to tell you what you need to know.
For instance, the United States Oil ETF and the PowerShares DB Commodity Index Tracking ETF both use futures contracts in an attempt to track the prices of the commodities on which they focus. The oil ETF focuses solely on crude, while the commodity ETF has exposure to energy, grains, and metals. Yet as the long-term performance of the oil ETF shows, futures contracts don't always track the price of the underlying asset over long periods of time. Certain behaviors among derivatives can create tracking problems that will detract from returns if investors use the ETFs that own those derivatives for long-term investing purposes.
The iPath VIX exchange-traded note is an even more extreme example of using derivatives. The ETN tracks futures contracts in the S&P Volatility Index, which in turn is determined by looking at the prices of various options on the S&P 500 stock market index. This ETN has performed poorly in part because volatility in the stock market has declined dramatically in recent years, but the way that the volatility futures contracts themselves trade has exacerbated the decline for ETN investors.
Yet not all futures-based ETFs have to be losers. The U.S. Dollar Bull fund has exposure to futures contracts in the U.S. Dollar Index, which tracks the value of the dollar against several major foreign currencies. Owning the stock involves betting that the dollar will appreciate against those foreign currencies over time. That's been a winning bet over the past five years, even though a long period of weakness in the euro has come to an abrupt halt in 2017.
A more conservative derivative approach
Derivatives can actually reduce risk in a portfolio. The PowerShares Buy-Write Fund uses a covered call strategy, which involves writing call options against positions in stocks. The strategy has less volatility than just investing in stocks and produces greater amounts of income, at the expense of giving up a piece of the upside on the stocks the ETF owns. With a distribution rate of more than 3% and solid returns during the bull market, the PowerShares ETF aims to give more conservative investors a way to participate in the stock market without necessarily having the full risk of a pure unhedged long stock position.
Make a smart choice
ETFs that invest in derivatives aren't for everyone, and not all derivative ETFs actually function the way that most investors would want them to. By knowing the ins and outs of each particular ETF, you can make sure that you don't get any nasty surprises in your portfolio.
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