The exchange traded funds is certainly innovative and the increasing availability of single stock ETFs proves as much.
Yes, that’s right. A product born to provide diversified exposure to traditional asset classes such as stocks and bonds can now be used to access individual equities – a thought almost unthinkable when the first US-listed ETF debuted about 30 years ago.
Critics might be apt to assert that single stock ETFs are solutions in search of a problem, but that dismisses the point that many investors are capital-constrained and can only piece together bit positions in some venerable stocks. As of the close of domestic markets on April 10, nearly 50 US-listed stocks sported price tags in excess of $500 with many more in the $300 to $499 camp.
That’s the result of soaring stock prices (obviously) and years of lethargic split activity. The list of $500+ names includes Nvidia, BlackRock, Costco, Netflix and Domino’s Pizza, among a batch of other firms investors would like access to. In other words, single stock ETFs are finding audiences among retail investors.
Single Stock ETFs Rising, But Not Perfect
As of the end of the first quarter, there 60 single stock ETFs with a combined $7 billion in assets under management trading in the U.S. with the latter figure representing a double in the span of just three months. That’s confirmation that some market participants are embracing these products.
However, advisors should be on the lookout for clients that are getting too cozy with single stock ETFs because the name is often a mirage. The bulk of these ETFs have high fees – something not associated with many traditional ETFs and certainly not a fixture of individual equity ownership. Additionally, most single stock ETFs are either leveraged or are options-based strategies designed to deliver income on growth stocks with low or no dividends. Think Coinbase, Meta Platforms and Tesla, among others.
Leverage is certainly a risk for clients that are accustomed to the traditional way of owning individual stocks and those that are not knowledgeable of the drawbacks of geared ETFs.
“Consider a $10 stock that loses 10% one day (now $9) and gains 11.1% the next, finishing at $10 for a net return of 0%. Now double the action for the same $10 stock: lose 20% on day one ($8), gain 22.2% on day two, and finish at $9.78—a negative 2.2% return,” notes Morningstar’s Ryan Jackson. “This example is oversimplified but illustrates the challenge with leveraged single-stock ETFs’ inherent volatility. Over a longer period, the reference stock must rise consistently for returns to meet (or exceed) their stated leverage. Zigzagging up the mountain makes it hard for these products to reach the top.”
Translation: While an ETF promising to deliver 1.5x the daily returns of Meta trades at a significantly lower price than the stock itself, 99% of investors would likely be better off simply owning a smaller position in the stock than a larger chunk of the leveraged ETF equivalent.
Other Issues to Consider
While the income offered by some of the options-based single stock ETFs is compelling and well in excess of the dividends found with those stocks, clients need to understand how that income is sourced.
It comes by way of selling call options (covered calls), which means the upside of the fund is capped when the stock moves through the highest strike price of the options held by the ETF. Likewise, these products don’t feature much in the way of downside protection. Add it all up and it’s fair to say that single stock ETFs have an audience and can be useful, but they’re not suitable for all investors.
“Single-stock ETFs can meet the needs of a few. High-conviction traders with a single-day or shorter holding period may find them useful vehicles to express their views. After all, it’s hard for everyday investors to use leverage or construct their own covered calls,” concludes Jackson.
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