Other ETFs

Actively managed ETFs

The first exchange traded fund (ETF) - the “Spyder” - was listed for trading in 1993. For the next 15 years, only passively managed ETFs were available to investors. In 2008, the now-defunct investment bank Bear Stearns introduced the first actively managed ETF: the Bear Stearns Current Yield Fund. Although the bank essentially went out of business later that year, it helped start a new trend in the ETF market.

Actively managed ETFs, often called active ETFs, allow the fund manager to deviate from a benchmark index. For example, a large-cap active ETF might use the S&P 500 as its benchmark, so the manager would generally invest in S&P 500 stocks. However, the manager isn’t required to match the index’s exact holdings or weightings. If the manager is bullish on 150 of the 500* stocks in the index, they could choose to invest only in those 150 and avoid the other 350.

*Technically, there are more than 500 stocks in the S&P 500. As of mid-2023, there were 503 stocks in the index. Regardless, this is not important for test purposes.

As discussed in the previous chapter, active management has pros and cons. An active ETF can outperform its benchmark if the manager’s selections perform well. But the additional research and portfolio management cost money. As a result, active ETFs typically have higher expense ratios than traditional passive ETFs.

Active ETFs are gaining popularity, but passive ETFs that closely track their benchmark index still make up most of the ETF market. According to Morningstar, active ETFs comprise 4% of the ETF market but represent 10% of all ETF inflows (as of December 31, 2021). For test purposes, assume passive ETFs are the focus of general ETF questions on the exam. Only apply active ETF characteristics if the question or answer choices explicitly mention active management.

Inverse & leveraged ETFs

Investors who want to bet on market downturns or amplify gains sometimes use inverse and/or leveraged ETFs. These products involve considerable risk, so they’re generally suitable only for sophisticated investors.

Inverse (bear) ETFs aim to deliver the inverse (opposite) return of the index they track. If an investor expects a market or sector to fall, an inverse ETF can potentially profit from that decline. Here’s how the returns work:

An investor owns an S&P 500 inverse ETF. The S&P 500 goes up 3%. What is the investor’s return?

An investor owns an S&P 500 inverse ETF. The S&P 500 goes down 2%. What is the investor’s return?

Real world example - Direxion S&P 500 Bear ETF (ticker: SPDN)

Leveraged ETFs aim to deliver amplified gains and losses. The most common leveraged ETFs target 200% or 300% of the index’s return. A 200% leveraged ETF targets 2× the index’s daily move, and a 300% leveraged ETF targets 3×. Here are a few examples:

The S&P 500 goes up 3%. How would a 200% and 300% leveraged fund indexed to the S&P 500 perform?

The S&P 500 goes down 2%. How would a 200% and 300% leveraged fund indexed to the S&P 500 perform?

Real world example - Direxion Mid Cap 3x ETF (ticker: MIDU)

Leveraged inverse ETFs also exist. These combine the features of inverse and leveraged ETFs into a single product. Because they both invert and magnify returns, they can be especially risky:

The S&P 500 goes up 3%. How would a 200% and 300% leveraged inverse fund indexed to the S&P 500 perform?

The S&P 500 goes down 2%. How would a 200% and 300% leveraged inverse fund indexed to the S&P 500 perform?

Real world example - Direxion Technology Bear 3x ETF (ticker: TECS)

Inverse and leveraged ETF returns can be excellent or disastrous over short periods. Even sophisticated investors typically use these ETFs for short holding periods. In addition to the risk, these funds tend to be expensive to operate. Although you don’t need the mechanics for the exam, it costs money for a fund to obtain inverse and leveraged exposure.

Bottom line - inverse, leveraged, and leveraged inverse ETFs provide ways to make or lose quick money based on market fluctuations.