New single-stock ETFs are ‘recipe for disaster,’ experts say

Retail traders just got a new tool to make bigger bets on their favorite stocks, but advisors are warning about outsized risks.

The first single-stock exchange-traded funds debuted earlier this month, providing an easy way to magnify returns or bet against volatile companies like Tesla and Nvidia. Unlike typical ETFs, which include dozens of stocks or bonds, these new products concentrate on just one security. 

At a time when the market is experiencing wild swings and recession risks are growing, single-stock ETFs have the potential to entice amateur investors into speculative trades. U.S. regulators have voiced concerns about the products — which have existed in Europe for years — but ultimately approved their release.

“I don't think most retail investors should touch these things with a 10-foot pole,” said Nate Geraci, the president of The ETF Store, an investment advisor. “I could make a case that intelligent investors should steer clear from single stocks altogether, and now we're talking about adding leverage and inverse exposure? In my mind, that's a recipe for disaster.”

Here are the pros and cons of the new products: 

Advantages
Single-stock ETFs use derivatives to deliver, for instance, 1.5 or two times the performance of a company each trading day. Other versions bet against the underlying stock by delivering the inverse of the daily performance — so if the stock falls 5% in a day, the ETF will gain 5%.

AXS Investments has already released eight such funds — including for stocks like PayPal Holdings, Nike and Pfizer — and at least 85 more are currently in the works, covering some 37 companies. Bloomberg Intelligence estimates that the category could gather more than $1 billion in assets within a year of launching. 

Investment strategies

Top 5 ETF trends to watch

July 19, 2022 12:55 PM

The new products, like ETFs in general, make trading easier. Instead of having to open a margin account at a brokerage, investors can purchase them through their normal trading account alongside more traditional funds that track broader indexes, and it’s simpler than learning the complex world of options trading.

Also, you can’t lose more than your initial investment with these products, unlike normal trading on margin. 

The products allow investors to express a bullish or bearish view on a stock in a more convenient way, according to Matthew Tuttle, a managing director at AXS Investments. 

“These are for experienced retail traders, not just someone who likes to dabble from time to time and doesn't understand,” he said. “But for the more experienced retail traders, it’s a great product.”

Risks
SEC Chair Gary Gensler has said the new products “present particular risk,” while Commissioner Caroline Crenshaw noted that “investors’ returns over a longer period of time might be significantly lower than they would expect based on the performance of the underlying stock,” especially in volatile markets.

That’s because the funds rebalance daily, so a decline one day means the ETF is rising off a lower base the next. Take the ProShares Short S&P500 (ticker SH), which aims to achieve daily returns that are the inverse of the S&P 500 Index. The S&P 500 is down 10% over the past year, meaning you’d expect SH to be up 10%, but in reality its gain is only about 5%.

Despite these objections, SEC rule changes in 2019 and 2020 have allowed leveraged and inverse ETFs to launch more easily, paving the way for single-stock products. 

Tax

2 moves to cut tax bills for advisors facing lower income this year

July 26, 2022 10:12 AM

They’re also more costly for investors. The AXS TSLA Bear Daily (TSLQ), which returns the inverse of Tesla’s daily performance and has already attracted more than $38 million from investors, charges an expense ratio of 1.15%. By comparison, the average fee for actively managed ETFs is around 0.70%. 

Leveraged ETFs have long been favorites of retail traders, particularly the ProShares UltraPro QQQ (TQQQ), which delivers three times the daily performance of the Nasdaq 100. Yet until now, they have all tracked indexes, which tend to be less volatile than individual companies.

“There are some legitimate use cases for these products, but these things are definitely going to be most used by the traders and gamblers, the Reddit community,” said James Seyffart, ETF analyst for Bloomberg Intelligence. 

Ross Mayfield, an investment strategy analyst at Baird, said he wouldn’t recommend the funds to a client, especially to one trying to build long-term wealth. 

“There will always be a trader class that this is for,” he said. “The problem is that it’s accessible to all.”