What rising complexity in ETFs means for investors

The universe of ETFs in the US has evolved drastically from the simple low cost, tax efficient, and transparent vehicle that accelerated the democratization of investing, with a steadily growing shift towards derivatives-based strategies.

While some critics, including devotees of the late great Jack Bogle, might be concerned about the increasing complexity, Aniket Ullal, head of ETF Research at CFRA, argues it's not that simple.

"In 2024, 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," Ullal wrote. This shift has been driven by demand for products offering customized outcomes or enhanced risk-return profiles.

"This is not inherently a negative development – products like buffer ETFs use derivatives to provide structured outcomes to investors, which help to manage risk," the report noted.

According to Ullal, buffer ETFs now represent 40 percent of derivatives-based launches, making them far and away the category leader. While they're designed to protect against losses by trading some potential gains for downside protection, he said they could pose a challenge for investors as they require an understanding of factors like the reset periods and the remaining caps and buffers for each product.

Meanwhile, leveraged and inverse ETFs account for one-third of derivatives-based equity ETFs, with single-stock leveraged ETFs making up almost a tenth of the market. By enabling investors to make supercharged bets on individual stocks or indices, they often amplify the risks associated with any particular investment position. Leveraged and inverse ETFs have been around since 2006 without causing any major negative events, Ullal said – though industry experts and regulatory leaders have issued warnings about them.

"More leveraged ETFs are focused on single stocks, which by definition are more volatile than a diversified basket of stocks," Ullal said. "Additionally, assets and volumes tend to be pooled around the products with the highest leverage ratios."

Despite the rise in complex product launches, he said the majority of ETF inflows in 2024 went into more traditional funds. While derivatives-based ETFs made up 27 percent of all US ETFs at year-end, they captured just 7 percent of the year’s inflows.

Looking ahead, Ullal predicts that ETF complexity will increase further as issuers aim to differentiate themselves with solution-oriented offerings for retail investors and professional traders. 

"Flows trends this year will provide an indication of investor appetite for these new, more quantitative oriented products," he said. "It is a trend that regulators will also likely be watching to monitor the risks that investors are taking."