Are you an informed investor?
Single Stock ETFs Have Unique Risks;
Understand Them Before You Invest.
People invest to achieve financial goals, and every investor has different investment goals and risk tolerances. Various investment products exist to help investors across the risk-reward spectrum to achieve those goals. In 2022, a new investment product for retail investors called a Single Stock Exchange Traded Fund (Single Stock ETF) hit the market in the United States. While its name sounds like a simple “single” investment that a retail investor might want to add to their portfolio, Single Stock ETFs come with enhanced risks. Risks include lack of diversification, daily resets that lead to unexpected results, lack of understanding of the product by many invest ment professionals, and compounding that can lead to large losses. Investors should be aware of risks associated with Single Stock ETFs.
What is a Single Stock ETF?
Single Stock ETFs are complex investment products that pay positive or negative multiples of the market performance of the underlying security. These features are known as leveraged and inverse exposures. A Single Stock ETF differs from a more traditional ETF that combines multiple securities into a single fund to give an investor exposure to a market segment or asset class. Single Stock ETFs carry heightened risks because leveraged and inverse exposures can generate amplified or unexpected losses.1
Instead of reflecting a basket of stocks, Single Stock ETFs only track the performance of a single underlying security and typically are not designed to be held for more than one day. The value of a Single Stock ETF resets daily, adding another layer of risk to an already risky and complex product. A Single Stock ETF’s value can diverge significantly from the underlying stock, especially if it is leveraged or inversely leveraged, as shown in the following example.
What Does a Single Stock ETF Look Like?
Suppose that Fleetza Pizza, Inc. is a company that trades on a national stock exchange, and an ETF issuer offers two different Single Stock ETFs based on Fleetza’s stock price. The first Single Stock ETF is a 2x leveraged fund, and the second is a 2x inverse leveraged fund. On Monday, Fleetza is trading at $100 per share and it goes up ten percent to $110 per share at close. The 2x leveraged Single Stock ETF would earn 20% (or double the increase in price of the underlying stock), and go to $120 per share, while the 2x inverse Single Stock ETF would lose 20 percent, thus dropping to $80 per share. On Tuesday, the Single Stock ETFs reset their respective prices, and begin trading again. Fleetza’s stock then drops by an additional 50 percent that day, closing the day at $40 per share. The 2x leveraged Single Stock ETF would fall towards $0 (doubling the 50% loss that day),2 while the 2x inverse leveraged Single Stock ETF would now be worth $160 (doubling the day’s starting ETF share price of $80). Because of this type of volatility, Single Stock ETFs are meant to be actively traded, and their daily resetting features can cause their prices to diverge significantly from the prices of their underlying stocks. Leveraged ETFs are not designed to be long term investments. inverse exposures can generate amplified or unexpected losses.
Know Single Stock ETF Risks and Protect Yourself
Single Stock ETFs come with many of the same risks associated with their more complex leveraged, inverse, and inverse-leveraged ETF brethren. Here are some of the risk factors investors should be aware of when considering whether to invest in a Single Stock ETF:
- Self-Directed: Investors who direct their own investments should carefully read the prospectus for any Single Stock ETF before investing to truly understand the risks associated with the product. Gains and losses can be magnified by the compounding inherent in the investment.
- Recommended by a Professional: If an investment professional recommends the product, ask them to describe how it complies with their duties to you, whether as a fiduciary investment adviser or a broker-dealer who must only make recommendations consistent with Regulation Best Interest. Get second opinions from disinterested professionals before you invest in something risky or that you do not fully understand.
- Not in the Best Interest of Long-Term Investors: Since Single Stock ETFs reset daily and are intended for use by active traders. They are not intended for buy-and-hold investors. Regulators have noted it would likely be difficult for investment professionals to recommend Single Stock ETFs to retail investors consistent with the applicable standard of care. Ask about the ETF’s expected holding period before you agree to invest.
- New Products: Since these products are new to the retail investor market, no one truly knows how they will perform over time. As demonstrated in the example above, they can be highly volatile investment products.
- Lack of Diversification: A Single Stock ETF eliminates any diversification that might occur in a fund, which can magnify the potential losses for retail investors.
- Pressuring you to invest or trade: If the product is recommended by an investment professional, ask why it would be an appropriate investment. Often the most complex products sold to investors also have the highest fees.
- Compounding Losses: Investors should understand that there is a risk they may lose their entire investment in a Single Stock ETF. Never invest more than you can afford to lose.
The Bottom Line
Be careful when you invest in a complex product, especially those that are new to the market. Investors often look for ways to enhance their returns, but something that seems like a straightforward way of achieving that goal may come with more risk than meets the eye. If you cannot afford to lose your investment, use caution when considering a Single Stock ETF. Contact your local state or provincial securities regulator for resources to understand the risks associated with Single Stock ETFs.
Posted: November 2022
NASAA has provided this information as a service to investors. It is neither a legal interpretation nor an indication of a policy position by NASAA or any of its members, the state and provincial securities regulators. If you have questions concerning the meaning or application of a particular state law or rule or regulation, or a NASAA model rule, statement of policy or other materials, please consult with an attorney who specializes in securities law.
1 For more information, see FINRA’s Investor Insight from July 2022.
2If this were to happen, the sponsor of the ETF would likely choose to intercede (or be required to intercede by the terms of the ETF fund’s prospectus) before the share price literally reached $0.00 by closing the fund and redeeming all outstanding ETF shares at some minimal share price valuation.