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Single-stock ETFs: a daily dopamine rush for the brain, but a risky business for 99% of investors

By Sam Instone - September 13, 2022

I take long-term investing extremely seriously.

My team work to help end anxiety, increase clarity and cut through the complexity and noise of 'traditional' firms.

As such, I have no interest in day trading.

But there's no getting away from it. 

People like to gamble.

Most investors think of exchange-traded funds as a simple way to buy a diversified basket of individual stocks tracking an index or with exposure to a particular theme.

But if you’re chasing quick returns, now there are also so-called single-stock ETFs, allowing leveraged bets on individual stocks.

Here’s how they work.

Rather than owning individual stocks, these ETFs contain “swaps,” which are contracts where two parties agree to exchange cash flows of one asset for another.

These contracts magnify the daily exposure of the individual stock, and tends to “juice the returns in one direction or another,” explained Ben Johnson, director of global ETF research for Morningstar. 

“Oftentimes, it can be wildly different depending on the level of volatility,” Johnson said. The greater the stock swings, the larger the “volatility drag,” affecting your overall returns.

Single-stock ETFs provide leveraged or inverse exposure to popular individual names such as Tesla, Apple, Nike, PayPal, and Pfizer.

Returns are on a daily basis.

But they aren't cheap (any return is less fees and expenses). 

And many believe they may be too complex and risky for everyday investors. 

What do Dimensional Fund Advisors make of them?

According to Wes Crill, PhD and Head of Investment Strategies, single-stock ETFs may be a case of the "wrong thing done for the wrong reason".

Some investors may want greater exposure to their favourite companies or to express bearish views on their least favourite, but single stocks already have a wide range of outcomes, which is amplified when paired with leverage.

Leverage (from the French lever, to lift up) magnifies returns, which in turn amplifies volatility.

If you’ve ever used a lever to move a heavy object, you know the force is amazingly powerful and equally dangerous.

These ETFs take the idea of leverage and distill it down to the narrowest possible focus. By trading them, you can dial up the daily returns on a single stock by up to 100%.

When you leverage, you use someone else’s money to amplify an investment’s gains—and its losses.

If, on July 22, there had been a single-stock ETF when Snap Inc.'s shares fell 39%, investors would have suffered hugely. 

A double-leveraged ETF on Snap—which, so far at least, doesn't exist—would have lost 78% that day.

Let's look at this another way:

Suppose you bought $100 of your favorite stock. If it declines by 10% that day and then rebounds by 10% the next, your investment drops to $90 the first day and ends up at $99 the second.

Now suppose you had doubled your exposure via leverage.

The same 10% decline and rebound in the stock would drop your investment to $80 before bringing it back up to $96. The 2x exposure didn’t merely double but rather quadrupled your loss.

A technical example (this can also be expressed algebraically) but hopefully you see the point.

Dimensional has done their research, as ever

It’s one thing to amplify broad-market-level volatility; it’s another thing to amplify single-stock volatility.

The average annualised median monthly standard deviation of individual US stocks is around 38% historically, which is about double the S&P 500’s historical level of volatility at 19%.

A one-standard-deviation decline of 38% would translate to a 76% loss at 2x leverage. 

In simpler terms, single-stock ETFs forget a fundamental investment principle—diversification.

Research tells us investors cannot reliably predict which stocks will outperform the market.

Furthermore, the median stock underperforms the market.

Single-stock ETFs could mean neglecting to capture the equity, small cap, value, and high-profitability premiums, missing out on top performers as they emerge, and failing to fully take advantage of the benefits of diversification. 

In my opinion, they are simply tools that gamify investing.

There is no diversification, very high costs and are simply not necessary for the majority of people.

Particularly not those who are looking to build predictable wealth, over the long term. 

Not simply a daily fix. 

Because of the features of these products and their associated risks, it would likely be challenging for an investment professional to recommend such a product to a retail investor while also honoring his or her fiduciary obligations.

I'm sure this won't stop the 'traditional' financial services industry. 

But I hope it can act as a small warning sign for the normal investor next door. 

Those who simply want to maximise their opportunity to capture the extraordinary returns of capital markets (in the most efficient way).

If this sounds like you and you feel you need a helping hand - please get in touch.

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