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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 now there are also so-called single-stock ETFs, allowing leveraged bets on individual stocks.
However, regulators and advisors warn these products may be too complex and risky for everyday investors.
“Single-stock ETFs are inappropriate and way too risky for over 99% of investors,” said certified financial planner Jason Siperstein, president at Eliot Rose Wealth Management in East Greenwich, Rhode Island.
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.
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While these products may offer some investors exposure to harder-to-access stocks, without an understanding of the “nuance and complexity,” average investors may have a bad experience, Johnson said.
Despite approving single-stock ETFs in July, the Securities and Exchange Commission has voiced concerns.
“Investors’ returns over a longer period of time might be significantly lower than they would expect based on the performance of the underlying stock,” SEC Commissioner Caroline Crenshaw said in a July statement. “These effects are likely to be especially pronounced in volatile markets,” she said.
Some financial asdvisors have also cautioned everyday investors about the volatility of these assets.
“In my opinion, these are tools that gamify investing, which I think can be very dangerous,” Siperstein said. “There is no diversification, very high costs and are simply not necessary for the majority of people.”
The expense ratios for single-stock ETFs are closer to 1%, and the average cost for passively managed funds was 0.12% in 2021, according to Morningstar.
Vaughn Kellerman, a CFP with HCM Wealth Advisors in Cincinnati, said single-stock ETFs are more suitable for day trading rather than long-term investment, echoing the SEC’s concerns about the possibility of magnified losses.
While it’s possible to “maximize” returns if you bet correctly on the asset’s movement that day, there’s also greater loss potential on the downside, he said.
For example, if the underlying stock moves down 10%, this product may be down 30% to 40%, Kellerman said.
In the same SEC statement, Crenshaw added that these products’ features and risks “would likely be challenging” for investment professionals to recommend to retail investors while fulfilling their fiduciary obligations.