- What is an ETF? Why is this considered a derivative product? How does it offer advantages in investing in the stock market?
Exchange Traded Funds (ETFâ€™s)
ETFâ€™s are a relative new comer to the world of investing but have become very popular. Like a mutual fund an ETF has a fund manager and is created by a fund family, in this case usually a brokerage firm. These funds mirror a index or average and trade on a stock exchange similar to a closed end fund. The basket of investments that mirror an index trade for a percentage of the actual index (ex; the S & P 500 Index might be 1,000 but the ETF would sell for 100). These ETFâ€™s have very low fees associated with it and can be liquidated at any time during the trading day. Taxes are only transferred to the owner of the ETF when one of the companies is no longer listed in the index and must be sold.
Not only can you invest in the ETF but an investor can also use options (calls and puts) listed on the option exchanges for the ETFâ€™s to diversify their portfolio.
Common ETFâ€™s are the SPIDERS (S & P 500), QQQQ (NASDAQ 100) and the DIAMONDS (Dow Jones Industrial Average). There are also smaller ETFâ€™s that specialize in certain sectors such as the Financial SPIDERS that invest only in the financial companies that are part of the S & P 500.
Variations on the traditional ETF
A leveraged ETF is similar to a typical ETF in that it mimics the index that it is based on. For example an ETF that is based on the S & P 500 will mirror the returns that are found by the S & P 500. They do this by investing in the equities that are listed in the index. A leveraged ETF will use derivatives such as stock options, futures, forward contracts etc. to invest in the same equities that are in the index they are following but because they are using derivatives they can offer the possibility of higher returns that the index itself. For example; if we again use the ETF that is based on the S & P 500 the ETF will be invested in the same equities as the S & P 500 but instead of buying the equities itself they will use the derivatives associated with the equities in the index. By using derivatives the ETF can use leverage to offer greater returns than the index instead. If the ETF is a 2 times ETF then the returns will be twice the returns found in the index itself. If the S & P 500 increases by 1% then the 2 times S & P 500 ETF will have a return of 2%. Of course if the index decreases by 1% then the 2 times S & P 500 ETF will decrease by 2% creating larger losses than the index itself. These types of ETFâ€™s are used by aggressive investors and not for the passive investor.
An inverse ETF is again an ETF that mimics the investment of an index. In the case of an inverse ETF it will be created using derivatives such as put options, futures, forward contracts etc. to create positions that will move in the opposite direction of the index itself. An example of an inverse ETF would be one created on the S & P 500 that would use derivatives to move in the opposite direction of the S & P 500. If the index fell by 2% then the inverse ETF would increase by 2%. Similar to a leveraged ETF there are leverage inverse ETFæŠ¯ that will have greater moves then the index it is based. If the S & P 500 decreased by 2% a leveraged S & P 500 inverse ETF would increase by 4%.