Mega-Cap Rollercoasters: Basics of Single-Stock ETFs

August 1, 2024

Single-stock ETFs are now available, but these funds pose unique risks and aren't for everyone. Here are a few basics.

#--bcn-image--7002{display: none !important;}

For those who don't mind a white-knuckle ride, there's a relatively new track to consider: leveraged and inverse single-stock exchange-traded funds (ETFs). Investors may be surprised to learn that these ETFs are quite different from traditional ETFs.

Single-stock ETFs launched two years ago, despite reservations from the Securities and Exchange Commission (SEC). According to SEC Commissioner Caroline Crenshaw, single-stock ETFs pose a "high level of risk."

Unlike most ETFs, these new funds are linked to just one underlying stock, to which they provide leveraged or inverse exposure. This type of ETF has the potential to be much more volatile and riskier than most exchange-traded products.

Traditionally, ETFs track indexes, which represent baskets containing anywhere from several dozen to several thousand securities. For example, a handful of ETFs track the S&P 500^® index (SPX), which contains around 500 stocks.

Equity indexes tend to blunt the impact of events that are specific to a single company. For example, a successful product launch may cause a stock to zoom higher, while a cyberattack might cause another to plunge before heading into a barrel roll. ETFs tracking indexes with numerous stocks are less impacted by the zigs and zags in stock price that are specific to a single company's performance.

Single-stock ETFs that offer leveraged or inverse exposure ratchet-up the already higher volatility inherent in a single stock by multiplying the stock's daily returns by a stated multiplier.

These funds aim to produce a multiple of a stock's gains or losses, meaning there's a chance of very rapid price changes. Anyone trading these products faces exaggerated losses if they take a position and the market goes the other way. Of course, a successful trade implies possible exaggerated gains, but investors need to keep the risk in mind and take extra caution if they venture into single-stock ETF trading.

The amount of leverage or inverse exposure is commonly indicated by a fund's name. There are currently leveraged single-stock ETFs that offer leverage up to 2x, and there are currently inverse single-stock ETFs that offer inverse exposures of –1x, –1.25x and –2x.

Leveraged long single-stock ETFs: Say a single-stock ETF includes "2x" in its name. That means, for example, if Tesla (TSLA) shares rise 6% in a single day, the shareholder of a TSLA-based single-stock ETF may realize a 12% gain. But the same math applies to losses. If TSLA drops 6%, the ETF's loss would be double that, or for this example, a 12% loss in just one day.
Inverse, or leveraged, short single-stock ETFs: These funds aim to move opposite the share price and could be employed in a bearish strategy. For example, in a fund with –2x exposure, if TSLA drops 4%, the single-stock ETF would gain 8%. Conversely, if TSLA rises 4%, this fund will lose 8%.

To achieve leveraged or inverse exposure, these ETFs typically invest in swaps with large investment banks, which may create counterparty risk. This is the risk that the other party in an investment contract may not fulfill its side of the agreement. To a lesser degree, these ETFs may also hold other types of derivatives like futures and options.

By the end of April 2024, total assets in leveraged and inverse single-stock ETFs were around $5 billion, and there are now more than two dozen such funds tracking companies including Amazon (AMZN), Meta Platforms (META), Nvidia (NVDA), and TSLA.

Growth has been fueled by heightened interest in mega-cap shares among active traders—and a high tolerance for risk among some. "Any stock can anchor a single-stock ETF, but the current offerings orbit around the most volatile ones," a Morningstar analyst wrote in April 2024.

Because NVDA and TSLA were two of the most volatile stocks in the S&P 500 during the three years that ended in March 2024, it's no surprise that nearly half of single-stock ETFs track one of these two companies.

Leveraged and inverse single stock ETFs can be highly volatile and risky and aren't suited for most investors, according to Emily Doak, director of ETF and index fund research at the Schwab Center for Financial Research.

"Volatility is the name of the game with single-stock ETFs," Doak explained. "These ETFs have the potential to generate extreme losses over a very short time period."

In fact, one leveraged single-stock ETF lost more than 24% on a single day in January 2024, while an inverse single-stock ETF experienced a loss of more than 33% in just one day last February. However, given their relatively short history in a relatively calm market, even bigger losses may be possible.

Doak also emphasized that most of these funds are only meant to provide the multiple of stated exposure over a single day. Because their returns are path dependent, holding them for more than a single day can result in outcomes that an investor might not expect. For example, holding a 2x ETF for a four-day period could result in the leveraged ETF underperforming the 1x, un-leveraged index, as shown here. It's important to remember that these are not "buy and hold" investments.

In total, the assets invested in single-stock leveraged and inverse ETFs represented less than one-tenth of 1% of all the assets invested in U.S. exchange-traded products (based on data from Morningstar Direct, as of April 30, 2024), indicating that most investors have seen the warnings and decided to skip this ride.

For active traders who are in front of their screens much of the day and are aiming to capitalize on short-term price swings, single-stock ETFs can be part of a trading strategy. However, even these traders will likely benefit from additional research and placing practice trades first by using a paper trading platform like the thinkorswim^® paperMoney^® feature.

Potential disadvantages of leveraged and inverse single-stock ETFs:

Can be highly volatile and riskier compared to traditional ETFs and traditional stocks (gains or losses of 30% are not uncommon for some single-stock ETFs)
Less diversified when compared to other ETF products like index-based ETFs that spread risk across multiple stocks
Higher-than-average fees and expense ratios (single-stock ETF ratios are typically around 1% or higher compared to ratios as low as 0.02% to 0.05% for ETFs linked to benchmarks like the SPX)

Bottom line

Single-stock ETFs have the potential to generate heart-pumping returns. However, unlike on an actual roller coaster where riders can be fairly certain they will end-up right back where they started, real investors might not be able to recover from the heartline drop in a leveraged or inverse ETF.

The volatile nature of leveraged and inverse single-stock ETFs means investors may want to keep their distance until they fully understand how these instruments work and weigh the risks involved.

Leveraged ETPs (Exchanged Traded Products, such a ETFs and ETNs), seek to provide a multiple of the investment returns of a given index or benchmark on a daily basis. Inverse ETPs seek to provide the opposite of the investment returns, also daily, of a given index or benchmark, either in whole or by multiples. Due to the effects of compounding and possible correlation errors, leveraged and inverse products may experience greater losses than one would ordinarily expect. Compounding can also cause a widening differential between the performances of an ETP and its underlying index or benchmark, so that returns over periods longer than one day can differ in amount and direction from the target return of the same period. Consequently, these ETPs may experience losses even in situations where the underlying index or benchmark has performed as hoped. Aggressive investment techniques such as futures, forward contracts, swap agreements, derivatives, options, can increase ETP volatility and decrease performance. Investors holding these ETPs should therefore monitor their positions as frequently as daily. To find out more about trading Leveraged and Inverse Products, please read Leveraged and Inverse Products: What you need to know.

All ETFs are subject to management fees and expenses.

Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. Shares of ETFs are not individually redeemable directly with the ETF. Shares are bought and sold at market price, which may be higher or lower than the net asset value (NAV).

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Investing involves risk, including loss of principal.

Supporting documentation for any claims or statistical information is available upon request.

0724-D99M