In the United States, investors can now tap into single-stock exchange-traded funds (ETFs) that provide enhanced and inverse returns based on the daily performance of specific stocks. However, these securities have garnered the scrutiny of professionals and regulators who caution that these novel funds pose substantial risks to the majority of investors.
Let’s explore the world of single-stock ETFs and the associated risks that investors should be aware of.
What are single-stock ETFs?
Single-stock ETFs employ derivatives to offer amplified and inverse returns on individual stocks.
For instance, consider Tesla (TSLA) when it’s about to announce its earnings, and you hold a strong bullish or bearish view of the outcome. Traditionally, you might buy or short the stock to capitalize on your perspective. However, single-stock ETFs now enable you to potentially magnify your returns by seeking to double the stock’s daily performance or provide double or 100 percent of the inverse performance, thereby placing advanced trading tools within reach of everyday investors.
In essence, single-stock ETFs grant you access to leverage typically requiring approval from a broker for margin accounts or options trading.
Bryan Armour, Director of Passive Strategies Research at Morningstar Research Services, explains, “Single stock ETFs are highly speculative and designed to offer leveraged exposure to individual stocks. The stated level of leverage or inverse exposure is reset daily, making these short-term vehicles unsuitable for long-term holding.”
AXS Investments has introduced a range of single-stock ETFs based on companies like Nike (NKE), Tesla, Pfizer (PFE), and PayPal (PYPL). Subsequently, GraniteShares, another fund company, launched its own collection of single-stock ETFs in August 2022.
These funds have been permitted to proceed thanks to a 2019 decision by the Securities and Exchange Commission (SEC), which allows ETFs meeting specific criteria to enter the market without first requiring approval from the SEC.
Risks of single-stock ETFs
Single-stock ETFs come with a range of potential risks that investors should exercise caution about, including:
- The fund’s performance over periods longer than one day may significantly deviate from the underlying stock’s performance due to daily rebalancing and compounding effects.
- These funds focus solely on a single stock, which means investors won’t benefit from the diversification advantages available in more traditional ETFs that encompass a variety of stocks across different economic sectors.
- These funds are designed for short holding periods, making them better suited for traders rather than long-term investors.
- The fees associated with single-stock ETFs can be considerably higher than those of traditional ETFs, such as S&P 500 index funds.
In August 2023, the SEC issued an updated investor bulletin, cautioning consumers about the risks associated with leveraged single-stock ETFs, emphasizing that “investors who hold these funds will face even greater volatility and risk than those who hold the underlying stock itself.
According to Rob McDougall, Vice President of Investment Strategy at Zhang Financial, it’s unlikely that these new funds will align with the needs of conventional investors.
“We wouldn’t include these products in our wealth management practice,” McDougall remarked, expressing a preference for long-term holdings like mutual funds, ETFs, or stocks. He emphasized that leveraged and inverse ETF positions demand daily management, which doesn’t match their investment approach.
Bottom line
Ultimately, single-stock ETFs are most suitable for experienced traders and investors with a firm grasp of the associated risks. If you belong to most investors focused on long-term objectives like retirement savings, including single-stock ETFs in your portfolio may not be a prudent choice. Instead, consider adhering to diversified funds that mirror comprehensive market indices and prioritize cost-efficiency for your investments.