If you’re familiar with or invest in exchange-traded funds, it’s likely you’ve heard of derivatives ETFs, a category of ETFs that use derivative instruments such as futures and forward contracts, swaps, options and even the use of debt to bet on the price movement of specific underlying assets.
If you’re not familiar with derivatives ETFs, this article provides a theoretical situation to help explain the three types of derivatives ETFs you should know.
Let’s say you have a portfolio that consists of just two ETFs, the first being the SPDR S&P 500 ETF Trust (NYSEARCA:SPY), which tracks the S&P 500 and the second being the iShares 7-10 Year Treasury Bond ETF (NASDAQ:IEF), which tracks the ICE U.S. Treasury 7-10 Year Bond Index, a collection of U.S. Treasury Bills with maturities between 7-10 years.
By using leveraged ETFs, inverse ETFs and commodity ETFs appropriately, you can improve your overall performance, but it’s not for the faint of heart.
Derivatives ETFs: Leveraged ETFs
Investors use leveraged ETFs for one reason: to amplify the daily gains of a particular index or underlying asset.
Best bought and held for very short periods — a day, maybe two — a 1% gain on a single day of trading becomes a gain of 2% or more depending on the amount of leverage used.
So, let’s say you felt the S&P 500 was headed for a big day based on positive earnings news before the opening of the day’s trading. Maybe you thought the S&P 500 was going to jump by 1% or more on the day, something it did 23 times in the first three months of 2018 alone, which is about 36% of the time.
Those are pretty good odds.
However, rather than buy more SPY, you’d purchase the ProShares Ultra S&P 500 (NYSEARCA:SSO), which seeks a return twice the index for a single day of trading. This way, you keep your 60/40 allocation while betting on the short-term price movement of the index itself.
There’s the temptation to think that if this leveraged ETF helped you double your short-term returns without having to borrow money, it might make sense to buy the ProShares UltraPro S&P 500 (NYSEARCA:UPRO), which seeks to deliver a return three times the index in a single day.
While it’s possible you’d be right, I wouldn’t try it with money you can’t afford to lose.
Finally, if you’re thinking about buying these leveraged ETFs — they have much higher management expense ratios than typical index ETFs — to buy and hold: don’t. The leverage is reset on a daily basis. Choppy markets can magnify the returns to the downside as a result of compounding, which works in both directions.
Derivatives ETFs: Inverse ETFs
Inverse ETFs are another type of ETF that uses derivatives to bet on the direction of an underlying asset, index or benchmark. Only in this instance, the ETF is intended to deliver the exact opposite performance of the underlying asset or index.
The reason investors buy inverse ETFs is that they’re easier to trade on a short-term basis than shorting ETFs when implementing hedging or market-timing strategies.
However, if you’re planning to bet against an index for an extended period, you’re better off finding a broker to loan you the ETF.
Let’s say you think the S&P 500 is going to fall in value over the next six months. You short the SPY, receiving the proceeds from the sale of the ETF. If the S&P 500 in fact, rises in price, you could be asked to buy back the ETF shares at a loss. Also, any dividends paid out while borrowing the ETF must be paid to the owner of the ETF shares.
As well, there is no limit to how much you can lose when shorting an ETF because if the SPY keeps going up in value, you have to repay the shares at a much higher price.
Buying an inverse ETF like the ProShares Short S&P 500 ETF (NYSEARCA:SH) — which is intended to deliver (-1x) the performance of the index — would accomplish the same thing as shorting the stock over the short term while providing a floor as to how much you can lose (the price paid for the ETF). That is unlike shorting, where the losses are unlimited.
However, just like leveraged ETFs, compounding of the negative kind over more than a single day can result in losses that are significantly more magnified than if you were shorting the SPY.
Inverse ETFs, like leveraged ETFs, are really only for experienced investors who understand how derivatives are used to mimic the returns of the underlying asset or index.
Derivatives ETFs: Commodity ETFs
When it comes to commodity ETFs, there are two kinds: those that hold the physical asset and those that use derivatives to mimic the price movement of the underlying asset.
GLD is an example of an ETF that holds the physical asset. An example of an ETF that uses derivatives to track the price of a commodity is the United States Oil Fund LP (NYSEARCA:USO), which tracks the daily price movements of West Texas Intermediate (WTI) light, sweet crude oil.
If you’ve been paying attention to oil prices lately, they’ve been steadily rising, delivering strong returns for owners of USO.
While the long-term track record of USO has not been good due to low oil prices — USO has averaged an annualized total return of 12.8% since its inception in April 2006 — recent returns, not surprisingly, have been much better.
Year to date and over the past 52 weeks, USO is up 20% and 42% respectively through May 14.
InvestorPlace contributor Todd Shriber does a good job explaining the downside of owning USO. “Although USO is not a leveraged oil ETF, it still comes with one of the same disclaimers: The longer you hold it, the bigger your potential for disappointment,” wrote Shriber in March 2017. “See, because it constantly rolls over derivatives and futures exposure, not only are its costs high (0.72% per year, or more than triple the average ETF’s yearly fee), but that constant rolling means the fund can (and does) deviate from the price of spot crude.”
What that means is that USO is very much like leveraged and inverse ETFs in that the longer you hold it, the less likely you are to achieve a return with minimal tracking error.
Like all derivatives ETFs, you’re better served using these for trading purposes than as buy-and-hold investments.
As of this writing Will Ashworth did not hold a position in any of the aforementioned securities.