U.S. stock investors have endured a challenging stock market this year.
Interest rate hikes, inflation, and a possible recession have dampened investor sentiment. The first half of the year saw US markets post their worst performance in 50 years, with major indexes slipping into bear market territory.
The wave of uncertainty has gotten investors thinking of vehicles that offer lower volatility and risks to their portfolios. One of such investment vehicles is Exchange Traded Funds (ETFs).
ETFs offer investors leeway for risk management because of the plethora of stocks pooled together in a single fund. But a new type of ETF has emerged on the scene - single stock ETFs. After trading in Europe since 2008, these more complex ETFs made their debut in the $6.2 trillion ETF market in the U.S. last July.
In this article we explore this type of ETF and if they are a viable option for investors hoping to manage risk and reduce volatility in their portfolios.
Unlike traditional ETFs that include a basket of holdings, Single-stock ETFs target a single stock using derivatives contracts to provide leveraged and/or inverse returns.
For example, a single-stock ETF may track Tesla stock using a 2x leverage. This suggests that it would increase the gains or losses of the stock by two times.
Single-stock ETFs allow investors who have a strong directional view on a certain stock and want to make a tactical trading decision based on company news such as earnings announcements or regulatory developments.
Using other people's money to make bets has been as old as the financial system.
Humans have always wanted to gain more for less. This trait could be linked to greed instinct. Scientists discovered that buying things on credit activates dopamine in the brain - the chemical responsible for pleasure-seeking behavior which causes addiction to drugs, video games, social media, etc.
Single-stock ETFs are just another way investors can use leverage to multiply profits or losses.
They are somewhat similar to other derivatives like margin trading, options, and inverse ETFs that use leverage to amplify gains. So while it may give investors another way to play stocks, it is merely a reinvention of the wheel.
Because single-stock ETFs use leverage, there are inherent risks to using these financial instruments. Let's look at some of them below.
The complexity of single-stock ETFs makes them suitable only for experienced investors that understand how to use leverage to trade stocks.
So, these are ill-suited to less sophisticated investors as their volatility could lead to losses if not properly managed.
Unlike traditional ETFs, these funds are not suitable for long-term investors.
Single-stock ETFs are leveraged instruments. As such the impact is compounded even if the price action of the underlying stock may be minimal.
For example, if Tesla stock rises 3%, a single-stock ETF with 2x leverage is designed to gain 6% that day and vice versa.
While this increases the probability of gain, it also increases the risk of loss exponentially. At best, they can be used for short-term trades which even require constant tracking.
Any daily reset leveraged or inverse product exposes you to volatility decay.
This is the share price deterioration associated with leveraged funds that must rebalance their portfolios each trading day to meet an advertised return relationship. As such, single-stock ETFs are prone to quickly lose value in volatile markets.
Trading may be halted: in recent times, we have seen stocks make exponential single-day moves.
Meme stock rallies, retail squeeze on stocks with high short ratios, or earnings beat could shoot up stocks as much as 50%. In such cases, the SEC may be forced to step in and halt trading on the stock. In the event of such a scenario, this could be bad news for those that invest in single stock ETFs.
Because of the way they are set up and their use of leverage, single-stock ETFs carry greater risk than ordinary ETFs. This makes them unsuitable for the average investor. Even the SEC warns retail and less sophisticated investors of the potential risks of using single-stock ETFs.
In the end, they're best suited to more experienced investors who understand the risks involved and can navigate them.
If you’re like most investors who are saving for long-term goals such as retirement, single-stock ETFs aren’t going to make sense in your portfolio. Stick with diversified funds that track broad market indexes and keep costs low for investors are a much better option in terms of risk management.