With S&P 500 at a new high, traders are gravitating to riskier ETFs

With the S & P 500 at a new high, many traders are gravitating toward riskier leveraged ETF products. It’s part of a broader trend, where investors are seeking out more complex exchange-traded funds. It’s been a topic for months on CNBC’s ETF Edge show: in the past year, there has been a huge increase in ETFs that employ complex derivatives strategies to obtain a variety of outcomes, from leverage on stock indexes and individual stocks to downside protection from a decline in the stock market, or even a decline in bitcoin. The ETF model: a victim of its own success Partly, this is due to the maturation and incredible success of the ETF model. The vast majority of the roughly $10.5 trillion in assets under management are in passive index-based funds like those that follow the S & P 500 ( SPY , IVV , VOO ). As the industry has matured, the business has sought to offer a broader array of products to the investing public. “I think we’ve transitioned from the passive boom to the complexity era,” Todd Sohn, head of ETFs at Strategas, told CNBC. “The bulk of investors are content with their low-cost options for equity and fixed income exposure. And so now, ETFs, especially issuers who are just trying to make it within the industry, are bringing what used to be hard to reach strategies for the masses.” The industry also wants to offer broader, more complex products because the industry has a dilemma: it’s never had more assets under management, but the low fees of traditional index-based ETFs (they have hovered around 15 basis points for equity ETFs , or $15 for each $10,000 invested) means the industry is constantly under pressure. Enter “alternative” ETFs. These ETFs typically use options to generate a desired outcome. They can be used to provide downside protection, generate income or magnify returns by using leverage , (borrowed money aimed to boosting a potential return). More importantly from Wall Street’s view: alternative ETFs charge higher fees, typically 60-100 basis points. More fees = higher profits. Alternative ETF strategies Buffer strategies: use options to provide downside protection Synthetic Income: use options to generate income (JEPI) Leverage/inverse: use derivatives to magnify returns Single-stock ETFs: amplified positions on individual companies Option/overlay: call options on underlying holdings Partly because we are in an up market, partly because some investors want downside protection, these “alternative” strategies are attracting inflows. New ETFs are increasingly complex In 2024, a record year for ETF inflows, 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, according to a new report from CFRA Research . Derivatives Based U.S. Listed Equity ETFs (Categorized by Type) Buffer 40% Leveraged/diversified 24% Covered Call/diversified 10% Leveraged/single stock 9% Other 8% Covered call/single stock 4% Currency hedged 2% Long-short 2% VIX 1% Source: CFRA Is this good or bad? It depends on whom you ask. Vanguard founder Jack Bogle railed against ETFs. More than 20 years ago, he said the ability to trade ETFs intraday would only encourage needless trading and churning. Bogle, who died in 2019, was speaking at a time when ETFs were dominated by index products. He would be howling at the moon if he saw what is happening now. Still, aside from some small blowups (notably the explosion of inverse VIX products in 2018, which came to be known as “Volmageddon”), derivative ETFs have not posed any systemic risks. At least not yet. “This is not inherently a negative development — products like buffer ETFs use derivatives to provide structured outcomes to investors, which help to manage risk,” Aniket Ullal, head of ETF research at CFRA, said in the report. “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,” Ullal added. In an up market, some want to amplify risk In an up market, many investors are gravitating toward the most risky products, including leveraged and inverse ETFs. Funds with leverage ratios of 3x or more account for 58% of the net assets in leveraged ETFs, Ullal noted. Will Rhind from GraniteShares runs a suite of ETFs that provide leverage on single-stocks live Nvidia. He explains how it works in my ETF Edge interview, available here . Others are looking to find protection against drops in stocks or, now, in bitcoin. On Wednesday, Calamos launched the Calamos Bitcoin Structured Alt Protection ETF — January (CBOJ), which provides 100% downside protection over a one-year period for bitcoin. The price? The upside is capped at a range of 10%-11.5%. Matt Kaufman at Calamos explained how the fund works, here . Because the traditional ETF space is dominated by mature, indexed-based ETFs, you can expect that ETFs will get increasingly complex as the industry continues to grow. Downside protection also available In an up market, there will be demand for leveraged ETF products. In a down market, there will be demand for downside protection ETFs. It helps that there is a vast social media network that spreads information about these products. “The internet helps these things spread now, via places like Reddit or wherever else there are those communities,” Sohn told me.