Exchange-traded funds are typically viewed by investors as an easy way to purchase a diversified portfolio of individual equities that track an index or have exposure to a certain theme.
However, there are also currently “single-stock” ETFs that provide leveraged bets on certain stocks.
Regulators and consultants caution that these products may be too risky and sophisticated for regular investors.
“Single-stock ETFs are inappropriate and way too risky for over 99% of investors,” stated Jason Siperstein, president of Eliot Rose Wealth Management in East Greenwich, Rhode Island, who is a licensed financial planner.
Here is how they function: These ETFs incorporate “swaps,” which are agreements between two parties to swap the cash flows of one asset for another, as opposed to holding individual equities.
Ben Johnson, head of global ETF research at Morningstar, said these contracts increase the daily exposure of the individual stock and tend to “juice the results in one direction or another.”
For instance, TSLL gives bullish investors 1.5X the daily returns of Tesa, with a daily reset of the leverage ratio.
“Oftentimes, it can be wildly different depending on the level of volatility,” Johnson said. The “volatility drag,” which lowers your overall returns, increases with market fluctuations.
Despite the fact that these products might give certain investors access to companies that are more difficult to access, Johnson warned that regular investors might not benefit from them because they lack knowledge of the “nuance and complexity.”
The Securities and Exchange Commission has expressed reservations despite the fact that single-stock ETFs were approved in July.
“Investors’ returns over a longer period of time might be significantly lower than they would expect based on the performance of the underlying stock,” Caroline Crenshaw, an SEC commissioner, stated in a statement in July. “These effects are likely to be especially pronounced in volatile markets,” she said.
Financial advisers have also issued warnings to regular investors about the erratic nature of these assets.
“In my opinion, these are tools that gamify investing, which I think can be very dangerous,” Siperstein said. “There is no diversification, very high costs and are simply not necessary for the majority of people.”
The expense ratios for single-stock ETFs are closer to 1%, while in 2021, Morningstar reported that the average cost for passively managed funds was 0.12%.
Single-stock ETFs are better suited for day trading than long-term investing, according to Vaughn Kellerman, a CFP at HCM Wealth Advisors in Cincinnati, echoing the SEC’s worries about the potential for inflated losses.
According to him, there is a bigger risk of losing money on the downside even though it is feasible to “maximize” gains if you properly predict how the asset will move that day.
According to Kellerman, if the underlying stock drops 10%, for instance, this product might drop between 30% and 40%.
The characteristics and hazards of these products “would likely be challenging” for investment professionals to propose to retail clients while upholding their fiduciary duties, Crenshaw added in the same SEC statement.