Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Investors have a new land mine to avoid: single stock ETFs

“Nothing surpasses the beauty and elegance of a bad idea.” –Craig Reucassel

Wall Street excels at taking a simple concept, complicating it, making it riskier, and charging a premium for it. Witness the latest financial land mine offering individual investors the opportunity to lose more money faster at a greater cost: single stock ETFs.

Individual investors now have a new way to make speculative wagers on whether Tesla will rise or PayPal will crash, and can even magnify their bets with leverage, by simply purchasing an ETF built around just one stock (for a fee, of course). But these leveraged and inverse single stock funds are not well understood by most investors and should not be considered as part of a long-term strategy.

The first Exchange Traded Fund appeared in 1993 as an alternative structure to traditional mutual funds. They were originally intended to provide low-cost, diversified, passive exposure by replicating broad indexes like the S&P 500. Today investors can choose from hundreds of very low-cost index ETFs with total expenses below 0.10% and many with no expenses at all. So far, so good.

Next came so-called leveraged and inverse ETFs that utilize borrowing and derivative contracts to increase exposure to the underlying index. Some fund companies rolled out products designed to move either with or against the index by up to a factor of 4 during a single day. Yet due to the complexity of their construction and some simple math, individual investors who held these speculative instruments for very long often paid tuition to the school of hard knocks. 

How could these risky funds be made even more hazardous? Wait for it: leveraged and inverse ETFs tied to a single stock. No kidding. Three fund companies, AXS Investments, Direxion Funds, and GraniteShares, have rolled out a handful of single stock ETFs that allow investors to make leveraged bets with or against individual companies including Tesla, Pfizer, Coinbase and Nike. In addition to the amplified risk of a leveraged ETF, these products compound the risk by betting on one company. Look out below.

Where to begin? All 3 issuers warn that these new products are highly speculative (duh) and are intended for sophisticated investors who trade on a daily basis. Of course, sophisticated investors have routinely made leveraged bets or shorted positions directly using margin and derivatives at far lower cost since Warren Buffet was in short pants, so these costly products should be of little interest. In reality, they are targeted at retail investors who are far less likely to actively monitor and trade each day and far more likely to absorb the inevitable value erosion endemic to leveraged and inverse funds. At least by going to Vegas you get to enjoy a nice show.

This begs the question of whether individual investors should be trading frequently in the first place (hint: no.) Numerous studies going back 30 years have consistently shown that between 80-90% of day traders lose money over time, and that less than 3% consistently outperform a passive index after fees. And remember that active trading including speculation with leveraged ETFs can result in substantial tax consequences due to short-term capital gains and losses.

Yet perhaps as hazardous as trading leveraged products every day is not trading them every day. There is a good reason why half of all the leveraged and inverse funds launched over the past 20 years have closed: due to their high cost, daily rebalancing, and magnification of gains and losses, they are mathematically expected to lose substantial value or even go to zero over a longer time horizon. Too many average investors have bought and forgot leveraged ETFs only to discover their performance varied markedly from the index over time.

Consider this oft-cited example. Suppose you purchase a leveraged ETF that targets 2 times the daily movement of a particular index. On day 1, assume the index and the ETF are each valued at $100. On day 2, the market surges by 10%, leaving the index value at $110 and the ETF at $120 (double the 10% gain or 20%). Now on day 3, say that the market falls by 10%, bringing the index down to $99 (90% of $110). However, the ETF value falls to $96 (80% of $120). The index has now lost a net 1%, but your leveraged fund is down 4%. This effect is referred to as volatility decay and illustrates why these products should not be held over time. Furthermore, the leverage readjusts every day back to 50/50, locking in any daily losses and eroding the original principal value. Through the course of a market cycle with ups and downs, leveraged and inverse ETFs diverge further and further from the cumulative value of their underlying indices.

Now add to the mix the inherent volatility of a single stock instead of an index, and you have the potential for some real mischief. Although the present SEC rules allow the introduction of these highly speculative bets, regulators have expressed concern and have warned advisors that purchasing or recommending these products for their clients may violate their fiduciary duty.

Someone is always laying new mines for average investors, and there are likely to be many more of these explosive gems deployed in the coming months. Try not to step on any.

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