An Exchange Traded Fund (ETF) owns large quantities of stocks, bonds, commodities, and/or other assets. The fund then divides ownership of those assets into shares, which are then traded on stock exchanges.
For example, an ETF tracking social media stocks would own Meta (Facebook), Snap, Twitter, and all other stocks in the space. It would then issue shares to investors that gave them a claim on a portion of the fund. Over time, the value of the ETF shares would rise/fall as the portfolio value changed due to the movement of the stocks within.
ETFs have solidified their status as an integral tool for all types of investors. They have also caught the eye of marketing departments on Wall Street, who are skilled at taking innovation that is meant to benefit investors and turning it against them.
One such product that’s new to the scene is “single stock ETFs.” These provide leveraged, hedged, and/or inverse returns on individual stocks. The SEC approved the first single stock ETF back in July, and since then, these funds have been getting a lot of press. But investors should avoid these like the plague for three reasons.
First, despite the name, single stock ETFs don’t own stocks. They own a mix of swaps and other derivatives to target a return profile. These often carry unique risks like “counterparty risk.” If the issuer of the derivative goes under, or the product itself fails for some unexpected reason (like a volatility spike), investors run the risk of losing all their money and fast.
This has happened before. Back in 2018, shorting the VIX was a popular trade. The VIX measures stock market volatility, so traders were using an exchange traded product comprised of derivatives to bet that volatility would fall. One day, the VIX spiked over 100%, causing it to drop 90% and the issuer to close the fund the following day. A $1.6 billion exchange-traded product vanished overnight, taking its investors’ money with it1.
Second, many of these ETFs use leverage to amplify the returns. For example, the Direxion Daily TSLA Bull 1.5X Shares (ticker: TSLL) offers 1.5x the daily return of Tesla. But levered ETFs are meant to only be held for a day and often become unreliable if held longer. Let's say that a stock priced at $100 falls by 20% on the first day to $80, rallies by 20% on the second day to $96, and then falls by 25% on the third day to end at $72 for a net loss of 28% from the original price of $100.
A triple-levered ETF tracking the same stock would fall by 60% on the first day to $40, rise by 60% on the second day to $64, and drop by 75% on the third day all the way down to $16 for a three-day loss of 84% from the original price of $100.
The problem is that while the stock would have to rise by 39% to get an investor back to even, the levered ETF would have to rally by a staggering 525%. Meaning, declines can have a devastating effect on the long-term performance of these products. Unless the stock being tracked rises forever, it is virtually impossible for levered ETFs to track properly.
Third, anything “new and innovative” from Wall Street comes at a price. The expense ratios on single stock ETFs are staggeringly high – often above 1%. And since there are fewer shares of the ETF traded relative to the stock being targeted, the spread between the price to buy and sell tends to be wider (more costly). Paying more is fine if the value is there, but it’s hard to justify doing so for a product that introduces unnecessary risks.
The bottom line
Single stock ETFs are designed to be trading vehicles held for no more than one day. That’s it. In fact, despite the SEC approving them recently, they’ve issued a warning to investors to avoid them2.
But single stock ETFs are just one of many financial weapons of mass destruction that risk your financial future. The good news is that most really bad ideas share the same DNA, so here are three suggestions to help steer clear of them.
The first is leverage is not your friend. It is the enemy of all that is good in investing and should never be employed. Save debt for other assets like cars and homes where you feel comfortable making the payments and the lender won’t issue margin calls.
Second, always read the instruction manual and don’t jump into any investment product unless you and/or your financial advisor have a thorough understanding of how it works. For example, the United States Oil Fund (ticker: USO) attempts to track the daily price movements of U.S. crude oil. The name alone suggests that this is what it’s designed to do. However, USO doesn’t actually own oil (sort of like how single stock ETFs don’t own stocks), which is why the chart above shows that it’s done an abysmal job at tracking the price of oil.
Third, avoid anything that attempts to speed up the process. Investing is supposed to be boring and uneventful. Avoid market timing and any strategy that you would feel compelled to brag to friends about at a party.
The bottom line is that most financial weapons of mass destruction hide in plain sight. Look for warning signs and avoid anything that seems too good to be true.
Sources
2 https://www.sec.gov/news/statement/crenshaw-single-stock-etfs-20220711
Disclosures
This newsletter/commentary should not be regarded as a complete analysis of the subjects discussed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no guarantee that any investment plan or strategy will be successful.