Exchange traded funds (ETFs) are more popular with investors than ever. Just over the past year alone, the global ETF market grew from $10.1 trillion to $13 trillion.1 And what’s not to love? Like mutual funds, ETFs offer the benefit of diversification but with intraday liquidity, potentially lower fees, and tax advantages.
But as the ETF market has grown, it’s also become more complex. Beyond the traditional passive funds that track indexes like the S&P 500, there are now many ETFs that employ leverage, derivatives, and all manner of complex strategies. They may seek to achieve higher returns, but complexity doesn’t always translate to better results for investors.
The appeal of complex ETFs
"Complex ETFs" refers to a type of fund that uses more sophisticated (and complicated) investment strategies than traditional ETFs. They often aim to offer advantages such as enhanced returns, risk mitigation, or exposure to niche market opportunities. To better understand their appeal, let’s take a closer look at some of these products.
Advanced strategies for enhanced returns
Some complex ETFs employ strategies like leveraging or shorting assets in an effort to amplify returns. Leveraged ETFs, for instance, seek to generate a return that is a multiple (e.g., 2x or 3x) of the underlying index’s performance2. This can be attractive to investors seeking higher returns, but while these ETFs seek to amplify returns, they can also amplify losses.
The strategy behind leveraged ETFs is far from simple. By using swaps and other derivative instruments, these funds reset daily to maintain the same leverage ratio. Therefore, this rebalancing generates a daily return that is subject to compounding. Over time, this can lead to performance that diverges significantly from what the investor may expect based solely on the index’s cumulative return, especially in volatile markets.
Risk hedging and downside protection
Another selling point for some types of complex ETFs is their ability to help hedge risk or minimize losses in down markets. For example, inverse ETFs aim to deliver a return that is the opposite of their underlying index.3 An investor might consider such an ETF as a potential way to insulate a portfolio during periods of economic uncertainty or market corrections.
While this sounds like a good idea, the reality can be less clear-cut. Just like leveraged ETFs, inverse funds are typically designed for short-term use because of their daily resets. Holding an inverse ETF for extended periods can lead to unpredictable and sometimes undesirable results, including loses.
Access to niche and thematic strategies
Thematic ETFs are designed to offer exposure to macro trends that are difficult to trade through traditional regional, sector, or factor strategies.4 They tend to focus on areas like technological innovation, clean energy, or other popular investment themes, and seek to capitalize on specific trends or industries believed to drive the economy in the future.
While these products may provide exposure to unique sectors or rapidly developing new markets, they are often accompanied by challenges. Such strategies may charge higher fees and can be relatively concentrated within their niche, which reduces diversification.
Potential pitfalls of complex ETFs
While complexity might sound sophisticated, the reality is that complex ETFs come with their own set of risks and challenges.
Higher fees
Complex ETFs, whether actively-managed or employing leverage, usually come with higher expense ratios. Over time, these fees erode returns, especially when returns are modest or funds underperform.
Poor understanding
Retail investors often overlook the nuances of how complex ETFs function. For example, leveraged and inverse ETFs may not perform as expected over longer periods due to their daily resetting feature. The misalignment can result in disappointing performance compared to initial expectations.
Increased volatility
The very features that make complex ETFs appealing, such as leverage or niche exposure, can also heighten risk. Investors seeking quick returns from these products expose themselves to amplified volatility, which may not align with their risk tolerance or financial goals.
Lack of diversification
Thematic ETFs, in particular, often lack broad diversification by design. Their concentrated exposure to specific industries or trends leaves investors vulnerable to sector-specific risks and cyclical downturns.
Behavioral risk
Finally, the complexities of these products may exacerbate investors’ behavioral biases. For instance, investors might be tempted to buy into thematic ETFs after seeing significant past returns, only to suffer losses when trends fade or markets correct.
When less is more
For retail investors, the lure of complex ETFs often lies in their promise of higher returns, sophisticated strategies, or niche exposure. However, these benefits often come with trade-offs that can undermine portfolio performance.
The key takeaway? In our view, simplicity (more often than not) is likely to win the race. Traditional ETFs remain an excellent choice for most investors. They can offer time-tested diversification, transparency, and cost-efficiency—all while hopefully avoiding the pitfalls of more complex strategies.
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