In my hometown, we have a railroad trestle that goes over the James River. One late winter night, after snow sledding, my buddy and I walked across the snow-covered trestle in pitch dark. It wasn’t one of our brightest moves; it was a lose-lose with not much upside. That also pretty much describes the new single-stock ETFs.
In the last few years, we were introduced to some new investment products, such as electronic currencies, fractional ownership platforms, ESG funds (Environmental, Social, and Governance), and direct indexing, but none are as scary as leveraged single-stock ETFs.
Leveraged single-stock ETFs use derivative contracts (borrowed money) to magnify the return of a single stock. Leveraged funds, which track stock indexes, have been around for a few years, but the high-risk leveraged single-stock ETF hit the markets in 2022. These new ETF variations offer to double or even triple the value of the underlying stock and are off the charts in terms of risk.
These single-stock varieties have become popular among investors who tend to be gamblers. They have the potential for high returns but also huge losses. Here’s how they work. If you bought the two-times-long Microsoft ETF and Microsoft went up 5% tomorrow, your ETF would gain 10%. The catch is that those same numbers apply to the downside. If Microsoft falls 10%, your ETF will be down 20% for the day. These products are designed to track the performance of their underlying asset over a single day, and if an investor holds for a longer period, it could do much worse than the actual stock it is tracking.
When the market goes up, these do great, but when it is down, they drop fast. When electronic currencies and big tech companies were going higher and higher, these types of ETFs built a big fan base, but now volatility has entered the market, those fans are realizing the power of negative multiplication. Over the long period, these types of investments often lose money no matter what, even if the stock it trails goes up. The Wall Street Journal calls them “wealth destroyers.”
Many large brokerages are blocking their clients’ access to these products, but that isn’t stopping companies from issuing more of them. There are over 700 leveraged single-stock ETFs on the market, and about 200 of those were launched this year. Another 27 new single stock ETFs filed paperwork last week, including one that would be the first 5x fund. Meaning, if that stock dropped 20% the investor would lose 100% of their investment. They wouldn’t be releasing them if they didn’t have customers for them. Which goes to say, there is a sucker born every day.
I highly recommend that most investors steer clear of these types of funds unless they are highly skilled investors. Just because something is popular doesn’t mean it doesn’t have pitfalls. I suspect these will go down the same path as indexed annuities, a lawsuit waiting to happen. All in all, they just aren’t worth the risk.
My buddy and I crossed the railroad trestle and back again safely, but we vowed never to do it again. We were terrified when we heard the river rushing under us, 70ft below. We took a huge risk and got away with it. Investors shouldn’t do the same.
Have a blessed week!
Richard Baker
Opinions voiced above are for general information only & not intended as specific advice or recommendations for any person. All performance cited is historical & is no guarantee of future results. All indices are unmanaged and may not be invested directly.
All investing involves risk, including loss of principal. No strategy assures success or protects against loss.
The economic forecast outlined in this material may not develop as predicted & there can be no guarantee that strategies promoted will be successful.
Fervent Wealth Management is a financial management and services entity in Springfield, Missouri.
ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF’s net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors.
The longer the leveraged or inverse leveraged position is held the greater the divergences from target return can grow. Thus, they do not seek to achieve their stated investment objective over a period of time greater than one day and must be monitored closely. Leveraged and inverse leveraged ETF/ETN are riskier than similar benchmarked ETF/ETN that do not use leverage, may not be suitable for all investors, and should only be used by investors who understand the potential consequences of seeking daily leveraged investment results.