The Derivative Scare: Fear Mutual Funds, not ETFs

By Neil Plein
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A large, fundamentally false debate has been raging over allegations that Exchange Traded Funds (ETFs) are “derivative” investments; a term steeped in negative press and generally associated with high-risk investing. For this reason, many claim that ETFs are not suitable for your retirement plan, so instead, they advocate the continued use of mutual funds.

Unfortunately, the claim that all ETFs are derivatives is simply false. This is like saying all stocks are energy stocks, when the reality is, only some stocks are energy stocks. The same logic holds true for ETFs. To understand this, you must examine what a derivative is and what is really meant when something is labeled a “derivative.”

According to a recent Security and Exchange Commission (SEC) “Fact Sheet” a derivative is defined as: “a type of financial instrument whose value is derived from another underlying product, include such things as futures, certain options, options on futures, and swaps. A common characteristic of most derivatives, which are among a panoply of investments that a fund may make in managing its portfolio, is that they involve leverage.”

Leverage Remember that last word, “leverage.” Now let’s look at an example to help clarify the SEC’s definition of a derivative. Think of a farmer who grows corn. If you walked up to the farmer and bought an ear of corn from him, you would give the farmer some money and he would give you an ear of corn- transaction completed.

If instead, you approached the farmer and wanted to buy that same corn next year, but only wanted to pay today’s price because you think corn will be more expensive in the future;  you and the farmer (who thinks the price will be less next year) would enter into a contract “derived” from the actual corn.

You would give the farmer some small amount of money for the contractual right to buy the corn in the future at today’s price. If you’re right and the price of corn goes up a little, you have created leverage; your small investment has increased many times in value as a result of only a small change in the price of the corn it is derived from:

Derivative Example

Today

Value

Price of corn on January 1st

$100

Price you pay for contract with farmer

$1

Future

Value

Price of corn on March 1st

$105 (5% increase)

Value of contract on March 1st

$5 (500% increase)

Some ETFs are Derivatives ETFs that are priced based on the value of underlying derivatives do exist. This type of ETF represents an opportunity to profit in the same manner the buyer of the contract for corn profited. With an ETF derivative an investor may reap substantial gains or losses as a result of investing in the derivative portion of the corn contract, which changes radically, rather than investing in the actual corn itself, which changes far less radically by comparison (5% vs. 500% outlined above).

This is the distinction between an ETF being classified as a “derivative” or not- the underlying item; in this case the underlying item is “corn” or “contract.” The ETF itself is not the derivative. In a mutual fund, just as in a non-derivative ETF of say, the S&P 500, you own actual shares in 500 companies; not derivatives of those shares; actual shares.

If the ETF itself were defined as a derivative solely on the basis that it derives its value from another underlying product, then a mutual fund would be considered a derivative as well. But, the fact is, mutual funds are not considered derivatives so ETFs, which invest in a basket of securities, are not derivatives.

ETFs in Retirement Plans I do agree that derivative-based ETFs should be avoided in retirement plans. This conclusion is a no brainer since derivative based ETFs can create a potentially devastating effect, even from owning a very small amount; as their leveraging capabilities can have an exponentially magnified negative effect on the value of the fund as a whole.

On the other hand, including non-derivative based ETFs like (VOO, AGG, VEA) in the investment menu of a retirement plan is a positive step forward. ETFs benefit participants through low cost and improved performance, on average, when compared to actively managed mutual funds.

Raising Awareness Mutual fund proponents raised the bar in making derivatives a topic of concern in retirement plans. Unfortunately, this awareness has taken a wrong turn in misinformation concerning ETFs as a whole, to the point of stating that all ETFs should be avoided.

This misinformation is compounded by the fact that mutual funds also use derivatives. In fact, a recent study presented the top 3 mutual funds in 401(k) plans, all of which use derivatives as underlying investment options. If derivatives should be avoided in retirement plans, buy an ETF of the benchmark index for each mutual fund listed below:

Top 3 Mutual Funds in 401(k) Plans

Source: BrightScope study of over 50,000 plans released 10/3/10

Fund name

Derivatives

Benchmark ETF

American Funds Growth Fund of America (AGTHX)

YES

(VOO) – No Derivatives

Pimco Total Return (PTTAX)

YES

(AGG) – No Derivatives

American Funds EuroPacific Growth Fund (AEPGX)

YES

(VEA) – No Derivatives

Disclaimer: Invest n Retire, LLC does not provide tax‚ accounting‚legal‚ or financial planning services or advice. Information provided is offered only for general information and education purposes and should not be used as the sole basis for making financial‚ investment‚ or retirement planning decisions. Past performance is not a guarantee of future performance. If you have specific questions you should consult with your advisors.

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About Darwin Abrahamson
Darwin Abrahamson founded Invest n Retire‚ LLC (INR) in 2004. Since 1982 Darwin has worked with fiduciaries and pension administrators of qualified tax-deferred retirement plans. Darwin has written articles for several financial publications; including Financial Planning Magazine‚ Financial Advisors Magazine, and the Journal of Indexes. His articles have been syndicated by Universal Press Syndicate. Darwin wrote an article‚ Avoiding Redemption Fees in 401(k) Plans‚ for Financial Advisors Magazine in 2005. In response to a white paper published in the Journal of Indexes‚ June 2008‚ Darwin wrote a rebuttal‚ Debunking the Myth That ETFs Have No Place in 401(k)s.

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