A new, exotic ETF product hit the tape this week — single stock ETFs.
The ETFs, managed by AXS Investments, are the first of their kind to be approved by the Securities and Exchange Commission — though similar products have existed for years in Europe.
These new funds allow investors to short stocks like Tesla (TSLA), or make a levered long bet on a name like Nike (NKE) or Pfizer (PFE), with a regular brokerage account.
Another “democratization” of some of the riskier trades available to investment professionals.
Unlike many ETFs — which for some have become synonymous with index funds like the Vanguard 500 Index Fund (VOO) — these products are clearly intended for active traders and not passive investors. Reason being: leverage is commonly misunderstood and isn’t for the faint of heart.
Leveraged products can cause substantial losses for investors while the underlying stock chops around and appears to “do nothing.”
The goal of a 2x ETF, for instance, is to reflect two times the performance of the underlying stock or index each day. If performance is measured on a longer time period, the results can drastically differ.
Consider the following hypothetical example of a stock and its 3x ETF, which is trying to reflect the daily underlying performance of a given stock times three.
Both securities trading at $100 per share and experience seven volatile sessions where the stock trades up or down at least 10% over the period.
At the end of our hypothetical period, the underlying stock is basically flat while the 3X ETF is down over 40%.
Chopping around with volatility kills these products’ returns, which is the number one lesson investors need to remember.
Let’s look at another example of this dynamic, but one happening in the real world today.
The Nasdaq 100 (^NDX) has been under pressure all year and is currently down about 27%. The ProShares Short QQQ ETF (PSQ) attempts to return the inverse of a long position, while the ProShares UltraPro Short QQQ ETF (SQQQ) aims to return three times the inverse of that product each day.
PSQ — the unlevered short — has returned that which the Nasdaq 100 lost — or 27%.
The 3X version is returning a healthy 74% — but that’s shy of the 81% that an uninformed investor may have been expecting (3 x 27%.= 81%).
Over the last year, the performance difference gets more challenging, with the unlevered short up 13% while the 3x levered short ETF up only 9%. On longer time frames — check out the 5Y performance on the chart above, for instance — the imbalance only gets worse.
Regulators warn
Despite the SEC’s approval of the new ETFs, regulators have been warning investors about risks in these products. SEC chairman Gary Gensler has raised concerns about these new ETFs, and SEC commissioner Caroline Crenshaw has been outright critical.
“[I]n addition to presenting significant investor protection issues, in periods of market stress or volatility, leveraged and inverse products can act in unexpected ways and potentially contribute to broader systemic risks,” Crenshaw wrote this week on the SEC’s website.
Crenshaw also issued a warning to registered investment advisors (RIAs), saying it would be “challenging” for them to recommend these products while “also honoring his or her fiduciary obligations.”
Unlike stock brokers, RIAs have a fiduciary obligation to act in their customers’ best financial interests.
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Jared Blikre is a reporter focused on the markets on Yahoo Finance Live. Follow him @SPYJared.
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