What Are Single-Stock ETFs?

Single-stock exchange-traded funds (ETFs) allow investors to take leveraged or short positions in individual stocks using an exchange-traded product. Leveraged single-stock ETFs offer new opportunities for investors in a volatile market, but at a greater risk. These products are unsuitable for new investors and should be considered high risk. People with a strong foundation of investing knowledge and a high risk tolerance should not treat these as buy-and-hold opportunities. Single-stock ETFs are intended for short-term bets and trading. The U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) have both cautioned against their use by ordinary investors.

Basics

In the evolving landscape of financial instruments, the emergence of single-stock exchange-traded funds has reshaped the dynamics of trading individual stocks. These innovative ETFs, introduced in European markets in 2018, present a novel avenue for leveraged or inverse trading on a singular stock. Facilitating a seamless process for investors to go short on individual stocks without resorting to short selling, these financial tools aim to empower ordinary investors with a broader toolkit for maneuvering through volatile markets.

However, regulatory authorities caution that the unique construction and utilization of leverage in single-stock ETFs elevate the risk profile beyond that of conventional ETFs. Consequently, long-term investors are urged to exercise caution, as these instruments may be deemed unsuitable for their investment strategies.

Notably, in 2022, AXS Investments, a prominent financial firm, made a significant stride by launching eight single-stock ETFs with leverage capabilities in the United States. This marked a pivotal moment, extending the accessibility of these innovative products to a broader investor base, thus shaping the landscape of stock trading in the country.

How Do Single-Stock ETFs Work?

Exploring the intricacies of single-stock exchange-traded funds reveals a departure from conventional ETF structures. Unlike their counterparts that hold diversified portfolios, single-stock ETFs uniquely focus on a solitary stock while harnessing the power of derivatives contracts for leveraged and/or inverse performance. This departure from traditional ETF models introduces both potential gains and losses through its dual leverage nature.

In contrast to standard ETFs that typically track broad-based indices, single-stock ETFs showcase their agility by utilizing derivatives such as option contracts to amplify returns or provide inverse exposure. The risk inherent in leveraged ETFs transcends that of traditional investments, demanding vigilant consideration from investors. For instance, a 1.5× leveraged bull single-stock ETF strategically utilizes short-dated call options, yielding a net delta of +150. In contrast, a 2× bear single-stock ETF strategically deploys put options, resulting in a delta of -200. Understanding these dynamics is crucial for investors navigating the nuanced landscape of single-stock ETFs.

Risk Dynamics in Leveraged and Inverse Single-Stock ETFs

The risks inherent in leveraged and inverse exchange-traded funds, including those focused on single stocks, stem from their structural design. These ETFs exhibit a negative roll, introducing time decay that causes value erosion over medium and long holding periods, irrespective of underlying asset performance. Consequently, these financial instruments are tailored for day trading or extremely short-term holding.

Moreover, single-stock ETFs face heightened vulnerability to rapid value depreciation in volatile markets. A finance interview with anchor Jared Blikre emphasizes this susceptibility. Using a hypothetical scenario, Blikre outlined a sequence of market movements, revealing that a three-times leveraged ETF could incur a 40% loss despite a stable stock value.

Regulatory bodies such as the Financial Industry Regulatory Authority (FINRA) and the U.S. Securities and Exchange Commission (SEC) express concern about the adequacy of existing regulations in overseeing single-stock ETFs. Their consensus is that these instruments, with their elevated risk, may be ill-suited for most individual investors, necessitating caution and a nuanced understanding of the associated risks.

Evolution of Single-Stock ETFs in the U.S.

The advent of single-stock exchange-traded funds traces its roots back to 2018 in European markets, with their entry into the U.S. occurring in the summer of 2022.

AXS Investments, a prominent New York-based asset manager, made a significant move in July 2022 by introducing eight single-stock ETFs, enabling leveraged investments in well-known entities such as Telsa, Nvidia, PayPal, Nike, and Pfizer. Despite this initial offering, six of these products faced tepid reception and were delisted within a year of their launch.

Expanding on this trend, Direxion entered the scene in mid-2023, launching 12 single-stock ETFs featuring leveraged positions on tech giants like Google, Amazon, Tesla, and Nvidia. Subsequently, Rex Shares followed suit by introducing single-stock ETFs focused on Tesla and Nvidia. This dynamic evolution signifies the ongoing exploration and refinement of single-stock ETF offerings in the U.S. market.

A Single-Stock ETF Example

Under the ticker symbol TSLQ, the AXS TSLA Bear Daily ETF endeavors to mirror the inverse daily performance of Tesla (TSLA) shares at a ratio of -1×. To elucidate, a 5% drop in TSLA during a trading day would correspond to a 5% gain for the TSLQ Bear ETF on the same day. It is essential to note that, over time, the fund's returns may be marginally lower due to management expenses and associated costs.

Regulatory Framework for Trading Single-Stock ETFs

Despite being categorized as high-risk by regulators and market observers, single-stock exchange-traded funds found their way to the U.S. market for the first time in 2022. Notably, these ETFs fall within the purview of Rule 6c-11 under the Investment Company Act of 1940. This rule, coupled with recent amendments to stock exchange listing standards, establishes a framework permitting ETFs that meet specific criteria to enter the market directly, bypassing the need for explicit permission via an exemptive order from the U.S. Securities and Exchange Commission.

Distinguishing Single-Stock ETFs From Single-Stock Futures

Contrary to popular perception, Single-stock ETFs and Single-stock futures (SSFs) are distinct financial instruments. Single-stock ETFs, as exchange-traded securities, employ derivatives contracts (options) on individual stocks to yield leveraged returns. In contrast, SSFs, categorized as futures contracts, represent an agreement with an individual stock as the underlying security, each contract controlling 100 shares of stock. Despite an initially positive reception for single-stock futures in the U.S., their activity has dwindled over time.

Conclusion

In essence, Single-Stock ETFs and Single-Stock Futures are divergent financial tools. A single-stock ETF, functioning as an investment fund, employs derivatives for speculative positions on an individual stock. While these instruments offer the potential for elevated returns, their high-risk nature renders them a precarious choice for retail investors.