- Chip Rewey
Single-Stock ETF’s: The Next Wrong Thing?
Caveat Emptor! That is our advice to those seeking the excitement of investing in single-stock ETF’s.
We can’t think of a single reason that a single-stock EFT is a superior investment for an individual investor versus outright ownership of the underlying stock. On the contrary, we see many negatives:
1) Fees. Even though these new single-stock ETFs may have “low” fees, any fee over zero is less favorable than owning the underlying stock, especially for retail investors that can trade commission free.
2) Custodian/Structure risk: Many of these ETFs offer 1.5x-3.0x leverage on the underlying stock. This leverage itself presents risk to the ETF. For example, is the ETF creator (custodian) properly capitalized? Can they borrow efficiently to maintain leverage at attractive rates? Are there other risky exposures at the custodian that could jeopardize its capital base and therefore impact the ability to maintain the ETF?
3) Potential liquidity discounts: There is a risk that an investor will not be able to sell shares in the ETF on a one-for-one valuation basis. Because the ETF would likely trade with a bid/ask spread, buyers may demand a potentially meaningful discount from a one-for-one trade. If new buyers don’t bid to meet the ETF sale, the ETF would likely need to liquidate the underlying stock, at potentially levered share count totals, to meet the redemption, asserting pressure on the underlying shares and in turn the ETF.
4) Unlikely to see lower volatility: One of the reasons pitched for single-stock ETFs is to help investors withstand volatility. We think the opposite is likely true. Levered ETFs could swing wildly around the volatility of the underlying stock – specifically because of the leverage. Further, the size of the ETF or leverage may make the ETF, or underlying stock, a target for short sellers who may try to create volatility to spur investor redemptions, to create downward pressure on the underlying stock.
The only reason we see for the marketing of these single-stock ETFs to individual investors is to create a new revenue stream for the creators of the ETF.
The SEC Weighs In
On July 11th, Commissioner Caroline E Crenshaw published a statement on single-stock ETFs that has plenty of warnings for investors, and advisors.1 We have listed some of the most salient points, in our view, below:
1) “While I have expressed concern about leveraged and inverse ETFs before, I worry that these single-stock ETFs pose yet another, perhaps greater, risk for investors and the markets.”
2) “The daily rebalancing and effects of compounding may cause returns to diverge quite substantially from the performance of the, in this case, one underlying stock, especially if these products are held over multiple days or more.”
3) “in periods of market stress or volatility, leveraged and inverse products can act in unexpected ways and potentially contribute to broader systemic risks.”
4) “Because of the features of these products and their associated risks, it would likely be challenging for an investment professional to recommend such a product to a retail investor while also honoring his or her fiduciary obligations or obligations under Regulation Best Interest.”
While, for the reasons we listed above, would not purchase a single-stock for our clients in our fiduciary role – we note the SEC, in #4 above clearly states they see a fiduciary “challenge” to own these single-stock ETFs for clients. A further read even notes that the new SEC rule 6c-11 does not mention single-stock ETFs, despite single-stock ETFs “coming to market under that rule”. Who really wants to own a product that the SEC itself never intended to be introduced?
We remind investors to 1) Understand an asset before you buy and 2) Invest for the long-term with an eye on downside protection. For those excited to jump into single-stock ETFs, we add Caveat Emptor!
1. SEC commissioner Crenshaw statements on single-stock ETFs SEC.gov | Statement on Single-Stock ETFs
Rewey Asset Management is a registered investment advisor in the State of New Jersey