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Investors in the U.S. now have access to single-stock exchange-traded funds (ETFs) that offer amplified and inverse returns on the daily performance of individual stocks. But the securities have caught the attention of experts and regulators, who warn that these new funds present significant risks for most investors.
Here’s what you need to know about single-stock ETFs and the risks they come with for investors.
What are single-stock ETFs?
Single-stock ETFs use derivatives to provide leveraged and inverse returns on individual stocks.
For example, say Tesla (TSLA) is reporting earnings and you’re particularly bullish or bearish on their results. You might buy the stock or short the stock to potentially profit off your views. But single-stock ETFs now allow you to magnify the potential return by aiming to double the stock’s daily return or provide double or 100 percent of the inverse return, bringing sophisticated trading vehicles into the hands of everyday investors.
In other words, single-stock ETFs give you access to leverage that would normally require approval from a broker for margin accounts or options trading.
“Single stock ETFs are highly speculative and intended to provide geared exposure to individual stocks,” says Bryan Armour, director of passive strategies research at Morningstar Research Services. “The stated amount of leverage or inverse exposure is reset daily, meaning these are short-term vehicles not intended to be held over long periods.”
AXS Investments has launched a handful of single-stock ETFs based on companies such as Nike (NKE), Tesla, Pfizer (PFE) and PayPal (PYPL). GraniteShares, another fund company, soon followed with its own batch of single-stock ETFs in August 2022.
The funds have been allowed to move forward thanks to a 2019 Securities and Exchange Commission (SEC) decision, allowing ETFs meeting certain criteria to come directly to market without first obtaining permission from the SEC.
Risks of single-stock ETFs
Single-stock ETFs present several risks for investors to be wary of including:
- Returns on the fund over periods longer than one day may diverge significantly from the performance of the underlying stock because of daily rebalancing and the effects of compounding.
- Since the funds are focused on just a single stock, investors won’t get the diversification benefits that are available through more traditional ETFs that hold stocks across different sectors of the economy.
- The short holding period these funds are intended for means they’re geared more towards traders and not long-term investors.
- Fees on single-stock ETFs can be meaningfully higher than the fees on traditional ETFs, such as an S&P 500 index fund.
In August 2023, the SEC released an updated investor bulletin warning consumers about the risks of single-stock leveraged ETFs, noting that “investors holding these funds will experience even greater volatility and risk than investors who hold the underlying stock itself.”
Rob McDougall, vice president of investment strategy at Zhang Financial, said the new funds aren’t likely to be a fit for typical investors.
“We would not consider these products for use in our wealth management practice,” McDougall said, instead preferring to hold mutual funds, ETFs or stocks for multi-year periods. “These levered and inverse ETF positions would need to be managed on a daily basis.”
In the end, single-stock ETFs are best used by sophisticated traders and investors who understand the risks involved. 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. Instead, stick with diversified funds that track broad market indexes and keep costs low for investors.
– Bankrate’s Rachel Christian contributed to an update of this story.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.