Beyond Stocks & Bonds: How Derivatives Are Powering the Active ETF Boom

But increasingly, active ETFs have become more complex.

In fact, a large percentage of new active ETFs aren’t about bread & butter stocks or bond picking, but are about derivatives and options. For investors, this increasing complexity is just another point they need to navigate. Simply buying a fund because it’s active and promises index outperformance isn’t as cut and dry anymore.

To say the pace of active ETF growth has been ‘breathtaking’ would be an understatement. In just a few short years, the number of active ETFs has grown from a small handful of active products in 2010 to north of 1,765 by the end of 2024. The trend has continued this year with several legacy asset managers such as MFS and Cohen & Steers finally breaking into the ETF game.

Moreover, with many asset managers looking to exploit Vanguard’s expired ETF share-class patent, the number of active ETFs is expected to surge even more and they could overtake mutual funds in the future as the investment structure of choice for all investors.

The proof is in the pudding. Assets continue to climb across all active funds. According to State Street, active ETFs took in more than $200 billion in new money so far this year. Globally, State Street predicts that active ETFs will surpass $1 trillion in assets under management before the end of the month.

And it’s easy to see why active ETFs have become popular with investors of all sizes. The ETF structure can bring out the best in managers by reducing taxes, eliminating cash drag, and lowering costs in a portfolio. As such, many active ETFs have serious potential to outperform their passive peers and benchmarks.

But investors may not realize that many of the largest active ETF launches or newest funds aren’t focused on good old-fashioned stock- or bond-picking. The active management comes from something else entirely.

And that’s derivatives.

Derivative investing tends to conjure images of complex strategies and traders with six or so monitors watching trend lines and blinking screens. But basically, a derivative is a security that derives its value from an underlying asset or another security. Common examples of derivatives include futures contracts, options contracts, and credit default swaps. A corn futures contract derives its value from the spot price of corn.

Originally, derivatives were used as insurance or to lock-in the price of a commodity at a set price for a future delivery date. But futures, options, and CDs trading has exploded, with the total value of derivatives outstanding being north of $730 trillion.

So, what does this have to do with active ETFs? Well, it turns out that many recent active ETF launches—with some funds gathering billions of dollars—are all-in on futures and options.

According to a new CFRA research report, more than 40% of the new active ETFs listed in the U.S. used derivatives as a main component of their investment mandates. This is up from just 20% in 2014. By the end of last year, derivative-focused ETFs made up 27% of the total number by fund count.

Source: CFRA

The use of derivatives in ETFs isn’t necessarily new. Inverse and leveraged ETFs have existed since 2006 and use options to provide their 3x or -1x exposure. Likewise, currency-hedged international ETFs have also been a member of the toolbox for quite some time, allowing investors to get the ‘pure’ returns of international equities. Commodity ETFs that use futures were some of the earliest non-stock or bond products to launch decades ago.

What is new is that these freshly launched active funds have focused on using options for income or defining outcomes. For example, buffer ETFs use options contracts to create a price floor for the fund that kicks in when the market has a drawdown below this amount, saving investors from losses. Covered-call or buy-write ETFs use derivatives to generate steady monthly income from the option premiums written.

Some of these derivative-based active ETFs have become very big. For example, the JPMorgan Equity Premium Income (JEPI) has more than $39.7 billion in assets and is the largest active ETF. Numerous others exist and, as you can see from the CFRA data, more and more are being launched as we speak.

While there is nothing wrong with the use of derivatives in a fund or portfolio, many investors may not realize that synthetics and derivatives are driving their active ETF gains. After all, using derivatives is different from traditional stock-picking.

Moreover, many of these options ETFs may not deliver market-beating results. Option outlays work well in listless markets. Without direction, investors can gather premiums from the calls while still holding the underlying stocks to keep the options writing going. Buffer ETFs cap upside and may not produce enough gains in positive trending markets.

In a surging market—like the one that precluded this one—options strategies significantly underperformed. It’s better to hold the stock and ride the full capital gains. While it’s hard to judge when the market will turn, eventually it will. That could hinder many of these funds’ ability to win.

With that in mind, the surge in the number of options and derivatives focused on active ETFs may turn from a boom to a bust. And in that, investors need to be cautious when selecting from the litany of new active ETFs that have launched.

These ETFs were selected based on their exposure to options overlays and derivative mandates. They are sorted by their YTD total return, which ranges from -2% to 7.3%. They have expense ratios between 0.29% and 0.75% and assets under management between $98M and $38B. They are currently yielding between 4.9% ad 11.3%.

All in all, the surge of active ETF growth is very nuanced. Derivative-focused funds that use options, futures, and credit default swaps to produce returns have quickly become the largest category of active ETFs in terms of growth and represent one of the largest ETF categories in terms of the number of funds. However, it’s important to note that these funds aren’t like regular stock-picking ETFs and caution may be warranted before buying them.

Active ETFs are getting a boost from derivatives. Options and future-focused funds have seen a huge swath of launch activity and have gathered billions in assets. However, these funds are not like traditional stock-picking and warrant extra care before making the plunge.

¹ Wealth Management (January 2025). From Bogleheads to Gearheads: U.S. ETFs Are Rapidly Increasing in Complexity