Derivative-backed ETFs are taking off with retail investors

Derivative-enhanced ETFs, the next meme stocks? Derivative-backed exchange-traded funds (ETFs) are the latest financial instrument to be a day trading hit, luring amateur investors in droves with massive payouts, Bloomberg reports. These ETFs are gaining popularity in no small part thanks to “financial influencers” touting them on TikTok, Youtube, and other social media as an easy way to make big gains in a short time.

By the numbers: Derivative-backed ETFs boost returns on the stocks that they are linked to by overlaying them with options and other derivatives. Although usually sold as a defensive strategy, the options can be cashed-in, generating dividends with a 100% yield or greater. Both startup and legacy firms are piling in, with 164 derivative-based products launched in the US year-to-date. The category’s assets have also grown 6x over a five-year timeframe to some USD 300 bn, according to Bloomberg data. Their growth is contributing to a wider ETF boom, with the market now valued at USD 10 tn.

Too good to be true? Experts and regulators are growing increasingly concerned that day traders are jumping on the trend without understanding the full risks involved. Youtube tutorials and other media promoting these strategies are often sponsored and tend to gloss over the risks involved. “The most important thing the industry can do is make sure clients understand what to expect in these strategies. That’s actually what keeps me up at night,” JP Morgan asset manager Hamilton Reiner — who helped pioneer the new class of ETFs — told Bloomberg.

It’s basic arithmetic: Funds bestowing yields of 30% or more will undoubtedly erode their net-asset value, Reiner said. If investors are not careful, erosion in their holdings’ net-asset value can see their portfolio values wither away.

Regulators are also raising flags: “The number of self-directed investors has multiplied at the same time that product complexity has increased and access to an almost unlimited menu of financial products has grown,” investor advocate at the US Securities and Exchange Commission Cristina Martin Firvida told Bloomberg, referencing the explosion in the number and variety of derivative-backed ETFs and their rapid uptake by inexperienced traders. A recent review of financial influencer activity found that the vast majority of that content — both about ETFs and other financial products and strategies — did not comply with US Financial Industry Regulatory Authority regulations, Bloomberg says.

On the flipside: The new wave of ETFs is “democratizing access to finance,” Bloomberg wrote citing advocates of laissez-faire policies, with the new products allowing mainstream online traders to access financial strategies that were previously restricted. “There is a breaking down of traditional barriers because ETFs are direct-to-consumer products,” chief revenue officer at Tidal Financial Group Gavin Filmore said. “The minute I launch a product, every trader at home can buy it. It’s like a sneaker, it’s like a potato chip,” he adds.

MARKETS THIS MORNING-

Mainland China’s markets extended their rally before paring gains on the first day of trading after the country’s Golden Week holiday, as the country’s top economic planner unveils more details on the government’s planned stimulus package in a morning press conference. Other Asian markets are down in early morning trading, led by the Hang Seng Index, which tumbled 6.3%. Across the pond, it’s a sea of red for US futures, with the Dow Jones, S&P 500, and Nasdaq all down in pre-market trading.

THE CLOSING BELL-

The DFM fell 0.3% yesterday on turnover of AED 329.9 mn. The index is up 8.3% YTD.

In the green: National International Holding Company (+10.5%), Orascom Construction (+10.0%) and ENBD REIT (CEIC) (+7.4%).

In the red: Shuaa Capital (-6.8%), Agility (-4.1%) and Ithmaar Holding (-3.1%).

Over on the ADX, the index closed down 0.4% on turnover of AED 1.37 bn. Meanwhile Nasdaq Dubai closed up 0.2%

CORPORATE ACTIONS-

Chimera JP Morgan Global Sukuk ETF’s share class B will distribute dividends equivalent to USD 0.0101 per unit for its unitholders on 23 October, according to an ADX disclosure (pdf).

Adnoc Logistics & Services is set to distribute USD 136.5 mn (AED 501.3 mn) in dividends to its shareholders for 1H 2024, equivalent to AED 6.78 per share, according to an ADX disclosure (pdf). Payouts will take place within 30 days from 7 October.