Jack Bogle[1], the pioneering founder of Vanguard, often railed against the ETF as an investment vehicle. His primary concern was that ETFs would encourage excessive trading by retail investors, resulting in unnecessary turnover and trading fees. Despite his concerns, the ETF structure has generated substantial value for investors, by driving down expense ratios, increasing tax efficiency, and encouraging transparency of holdings. ETFs have also democratized access to strategies and asset classes that were earlier accessible primarily to institutional investors and high-net-worth individuals.
Nevertheless, as we start 2025, it is worthwhile to pause and reflect on the rapidly rising complexity of the ETF industry. In 2024, 40% of the new ETFs listed in the U.S. used derivatives as a significant component of their investment strategy, up from 20% in 2014 (see Figure 1). This is not inherently a negative development – products like buffer ETFs use derivatives to provide structured outcomes to investors, which help to manage risk. In aggregate, however, the new ETFs being listed are quite far removed from the industry’s traditional roots in low-cost replication of broad indices.
Categorizing the Derivatives-Based Equity ETFs by Type
It is useful to categorize the equity ETFs that use derivatives as a key component of their investment strategy, since not all may significantly amplify portfolio risk. Buffer products account for the largest share (40%) of these ETFs by count. They use options to provide range bound outcomes where investors can typically trade off some potential upside in exchange for downside protection. Although they help manage rather than amplify risk, they are complex since they require investors to understand details of the reset periods and the remaining caps and buffers on each product. Another category is leveraged and inverse products, which make up a third of all derivatives-based equity ETFs by number. Investors use these products to take more risks through concentrated, directional bets on indices or individual stocks. Derivatives are also used in ETFs for other purposes, such as income generation through call writing – e.g., in the JPMorgan Nasdaq Equity Premium Income ETF (JEPQ). Another application of derivatives is the use of forward contracts for currency hedging – e.g., in the X-trackers MSCI EAFE Hedged Equity Fund (DBEF).
Leveraged and inverse equity ETFs have been listed in the U.S. since 2006, without any major negative incidents. However, the availability and adoption of riskier products in the category is increasing. More leveraged ETFs are focused on single stocks, which by definition are more volatile than a diversified basket of stocks. Additionally, assets and volumes tend to be pooled around the products with the highest leverage ratios (see Table 1).Table 1 highlights how ETFs with leverage ratios of 3x or higher account for only 17% of leveraged ETFs in the U.S. by number, but 58% of the net assets. It underscores how investors tend to gravitate toward the most volatile products to take a directional view of a stock or market sector.
Looking Ahead
Although there has been an explosion in the number of derivatives-based ETF launches, most flows in 2024 still went into more traditional ETFs. At the end of December 2024, derivatives-based ETFs accounted for 27% of ETFs in the U.S., but only 7% of the inflows in 2024.
In 2025, it appears likely that the complexity of new ETFs will increase further. The traditional indexed space is quite mature and competitive, with issuers looking to offer more solution-oriented products to retail investors and professional traders. This will often necessitate more complex structures, including the use of derivatives. Flows trends this year will provide an indication of investor appetite for these new, more quantitative oriented products. It is a trend that regulators will also likely be watching to monitor the risks that investors are taking. This evolution from low-cost traditional indexing to more complex products will shape the future of the ETF industry over the next few years.
Aniket Ullal is SVP, ETF Research and Analytics for CFRA, one of the world’s largest providers of independent investment research. Aniket founded First Bridge Data, a leading source for global ETF data and analytics that was acquired by CFRA in August 2019.
[1] Note: The term Bogleheads is intended to honor Bogle and is used to reference passive investors who follow Bogle's simple but powerful message to diversify with low-cost index funds.
