ETFs, ETNs & Leveraged Funds

What an ETF is

• An exchange traded fund (ETF) is technically structured as an open-end management company, but it isn’t a mutual fund.
• ⚠️ Key confusion point: ETFs are organized like open-end funds, but they trade differently.
• ETFs trade on exchanges in the secondary market and are negotiable securities (they trade between investors).

Characteristics shared with open-end and closed-end funds

Trading mechanics

Sidenote — Zero commission trades

• For decades, it was standard for broker-dealers (financial firms that help their customers trade securities) to earn commissions on completed transactions.
• Today, many large discount broker-dealers don’t charge for trades, thanks largely to the growth of app-based platforms like Robinhood that began the $0 commission trend.
• Larger, well-established broker-dealers like E*Trade, Fidelity, and Charles Schwab slashed commissions to $0 in 2019 to compete.
• Many broker-dealers (especially small and boutique firms) continue to charge commissions.
• 📌 Therefore, you can still safely assume ETFs are subject to commissions.

Passively managed ETFs

• ETFs are well known for tracking indexes. Example: the S&P 500 “Spyder” ETF — investors make money when the S&P 500 rises and lose money when it falls.
• Passive investing: instead of selecting specific stocks, bonds, and other securities, you aim to capture the return of an index.
• Indexes track large segments of the market, so investing in a passively managed ETF is essentially betting on the “market average” rather than trying to pick the best individual investments.

Supporting research cited by the text

• The Wall Street Journal ran a multi-year experiment: writers were blindfolded and threw darts at lists of stocks; a portfolio was built from the stocks the darts landed on. Some of these portfolios performed better than professionally managed funds.

Over 100 six-month contests, the pros have racked up an average gain of 10.9%, compared with 4.5% for the dart throwers and 6.8% for the Dow industrials. The pros have come out ahead of both the darts and the Dow industrials 44 times.

• While the professionals averaged higher than both the Dow Jones Industrial Average and the dart throwers, they only beat both 44% of the time.
• Since professional (active) management also involves added costs and fees, results like these are often used to argue for passive management.
• 📌 The Dow Jones Industrial Average is a well-known index tracking 30 of the largest US-based stocks.

Active investing (the opposite approach)

• Focuses on selecting the best investments available (instead of “taking the average”).
• Active investors usually measure performance against an applicable index. Example: an active investor in large-cap stocks (stocks of larger companies) would likely compare performance to the S&P 500. If the portfolio outperformed the S&P 500, the investor “beat the market.”
• Active strategies try to consistently beat a comparable index, which is difficult to do year after year.

Just 26% of all actively managed funds beat the returns of their index-fund rivals over the decade through December 2021

• If you believe throwing darts at a wall can produce results similar to spending time and money on research, then passive investing may make more sense. ETFs provide an easy way to invest passively.

🔑 The three specific ETFs you must know

• The names of these ETFs are a play on the names of the indexes they follow.
• 📌 Today there are thousands of ETFs tracking many different indexes, but you only need to be aware of these three.
• Whether it’s a list of 500 of the most actively traded stocks (S&P 500) or a list of 30 of the most dominant publicly traded companies (Dow Jones Industrial Average), passively managed ETFs simplify a passive investment strategy. Many other indexes track everything from stocks to bonds to currencies to commodities and more.

Actively managed ETFs

• Actively managed ETFs (active ETFs) allow the fund manager to deviate from the benchmark index.
• Example: a large-cap active ETF would likely use the S&P 500 as its benchmark, and the manager would primarily invest in S&P 500 stocks. However, the manager isn’t required to match the index’s exact structure. If the manager was bullish on 150 of the 500 stocks in the index, they could avoid investing in the other 350.
• 📌 Technically there are more than 500 stocks in the S&P 500 (503 as of 2025). This is not important for test purposes.
• Pros and cons: an active ETF could outperform its benchmark if the chosen investments perform well, but the research and ongoing management provided by the fund manager and their team comes at a cost. As a result, active ETFs tend to have higher expense ratios than traditional passive ETFs.

Market share (Morningstar, as of 2024)

• ⚠️ Exam approach: assume passive ETFs are the focus of general ETF questions. Only apply active ETF characteristics if the question or answer choices explicitly bring them up.

ETFs vs. index mutual funds

Similarities

• Both are structured as open-end management companies.
• Both can provide the “passive” returns of indexes.

🔑 Key differences

• 📌 Mutual funds require more behind-the-scenes work that ETFs avoid (for example, costs related to redeeming securities). You don’t need to know the operational details.
• 📌 Definition of efficiency used by the text: the lower the fees/charges, the more efficient an investment is.

Leveraged & inverse ETFs

• Investors betting on market downturns or trying to amplify gains may use inverse and/or leveraged ETFs.
• These investments involve considerable risk, which makes them suitable only for sophisticated investors.

Definitions

Inverse ETFs

• Provide the inverse (opposite) return of the index they track.
• If an investor expects a market or sector to fall, an inverse ETF can be used to seek a positive return.

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

Inverse ETF: down 3%

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

Inverse ETF: up 2%

Leveraged ETFs

• Provide amplified gains and losses.
• 🔑 200% and 300% leveraged funds are the most common. A 200% leveraged ETF targets gains and losses that are 2× the index’s move; a 300% leveraged ETF targets 3×.

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

200% leveraged ETF: up 6% 300% leveraged ETF: up 9%

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

200% leveraged ETF: down 4% 300% leveraged ETF: down 6%

Leveraged inverse ETFs

• Combine inverse returns with leverage, which increases risk even further.

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

200% leveraged inverse ETF: down 6% 300% leveraged inverse ETF: down 9%

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

200% leveraged ETF: up 4% 300% leveraged ETF: up 6%

Quick-reference return table (from the worked examples above)

• With these ETFs, returns can be excellent or disastrous. Even sophisticated investors typically use inverse or leveraged ETFs only for short periods of time.
• In addition to the risk, these funds often have substantial fees. You don’t need to know the mechanics, but it’s expensive for funds to obtain inverse and leveraged returns.
• Bottom line: inverse, leveraged, and leveraged inverse ETFs can produce quick gains or quick losses based on market fluctuations.

Exchange traded notes (ETNs)

• Exchange traded notes (ETNs) are technically debt securities, but this material may discuss their similarities and differences with ETFs.
• Both ETNs and ETFs provide returns based on the performance of an underlying index, but they do it in different ways.

How each delivers the index return

• 📌 How ETN issuers provide the return of an index: you don’t need to know the details, mainly because the process is complicated and varies by firm. The key point is that ETNs obligate the issuer to make a payment equal to the return of an index.

Shared ETF/ETN traits

• ⚠️ Trap: ETFs have no default risk; ETNs do. The tax-efficiency ranking runs the other way — ETNs are more tax efficient than ETFs.

Key points

Exchange traded funds (ETFs)

• Structured as open-end management companies
• Negotiable securities

Passive investing

• Track the performance of indexes
• Pursues the return of the overall market

Passive ETFs

• Aim to match the returns of a benchmark index
• Low expense ratios

Active investing

• Picking the best individual securities in the market
• Attempts to outperform indexes

Active ETFs

• Aim to outperform the returns of a benchmark index
• Higher expense ratios than passive ETFs

Specific ETFs

• “Spyders” = S&P 500 ETF
• “DIAmonds” = Dow Jones Industrial Average ETF
• “Qubes” = Nasdaq 100 ETF

ETFs vs. mutual funds

• Trade status:
  • ETFs are negotiable
  • Mutual funds are redeemable
• ETFs have lower expense ratios
• ETFs are more tax efficient

Inverse ETFs

• Provide an inverse return of an index
• Only suitable for sophisticated investors

Leveraged ETFs

• Provide amplified gains and losses
• Amplify at 200% and 300% rates
• Only suitable for sophisticated investors

Leveraged inverse ETFs

• Provide an inverse return of index with amplified gains and losses
• Amplify at 200% and 300% rates
• Only suitable for sophisticated investors

Exchange traded notes (ETNs)

• Debt instruments
• Promise to pay the return of an index
• Subject to default risk
• Negotiable securities
• Can be bought on margin
• Can be sold short

Sources

Primary/official references for the material in this chapter. Every link was fetched and returned HTTP 200 on 2026-08-15.