This New Investing Trend Can Double the Returns of Single Stocks — but It's Risky
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Exchange-traded funds have exploded in popularity since 2000, growing from 66 at the turn of the century to 3,108 in 2023, according to the Investment Company Institute. They are now the most recommended investment by financial planners.
Today, ETFs come in all shapes and sizes. Thematic ETFs focus on specific industries like electric vehicles, AI or robotics. Others track the investments of members of Congress. There are even ETFs that aim to help close the gender gap.
Like any asset class, there are varying degrees of risk involved with ETFs, and the most recent development could be the riskiest yet. Single-stock ETFs are a type of leveraged fund that — unlike average ETFs — focus on an individual stock and its derivatives as opposed to a basket of holdings. And as they gain momentum, it's crucial for investors to understand the dangers before purchasing shares.
What are leveraged ETFs?
Traditional ETFs typically track an underlying index, or a section of the stock market used to demonstrate the general performance of the whole. For example, the first-ever U.S. ETF and largest by assets under management — the SPDR S&P 500 ETF Trust (SPY) — attempts to mirror the weighted holdings and performance of the S&P 500 index.
On the other hand, leveraged ETFs use financial derivatives like options to amplify returns of a benchmark. In doing so, they aim for returns that measure as multiples — twice, triple and sometimes as much as five times that of the underlying asset. For example, an ETF that is 2x leveraged to the S&P 500 will produce gains and losses double that of the index, while an inverse ETF that is -2x leveraged to the index will produce twice the gains or losses opposite of the benchmark's performance.
Recently, leveraged ETFs have taken a step further. Rather than aiming to compound the returns of broad-based indices, the emergence of leveraged single-stock ETFs now allows investors to magnify the returns of individual equities, like Nvidia and Apple.
However, there's mounting evidence that picking winning stocks isn't only difficult — it's highly unlikely. On Aug. 21, Peter Lazaroff, chief investment officer at Plancorp and BrightPlan, shared on his podcast that between 1926 and 2016, the median stock generated a return of -3.66% per year, with the top 4% of stocks (that's 1,092 out of 25,967) accounting for all of the net gains during that period. Just 90 companies — or 0.33% of all stocks — accounted for more than half of the return.
So as the line between ETFs and stocks begins to blur, is the leverage worth the risk? That depends on investors' individual preferences, goals and timelines. But for those with a higher risk tolerance, single-stock ETFs can provide tremendous returns in the short-term.
The pros and cons of single-stock ETFs
Rather than tracking the performance of multiple securities, like most ETFs do, single-stock ETFs — as their name suggests — just track one. As a type of leveraged security, they pay positive or negative multiples of the market performance of the underlying stock.
Importantly, these funds are not ideal for buy-and-hold investors who are taking the long view. Because they're inherently more volatile, they're alluring to active traders seeking to gain greater exposure to short-term price movements for individual stocks. If an investor holds a single-stock ETF for more than one day, short-term volatility has the potential to wipe out any prior gains.
The GraniteShares 2x Long NVDA Daily ETF (NVDL), for instance, aims to provide twice the daily returns of Nvidia's stock. The fund has provided enormous returns since its inception on Dec. 16, 2022, posting gains in excess of 1,488%.
So far this year, it's been the same story. As shares of Nvidia have gained around 153%, NVDL has doubled that by posting a gain of over 323%. While that might seem attractive, investors need to be aware of the downside risk also being twice that of Nvidia's performance.
This can be illustrated by using the market's mid-summer sell-off as context. Beginning on July 16, stocks began a pullback that ultimately resulted in the S&P 500 falling by 8.49% before bottoming on Aug. 5. During that period, Nvidia outpaced the market's losses, falling by more than 20%. But for holders of NVDL who failed to understand the fund's short-term nature, losses were doubled in a matter of 15 trading days, registering a whopping -39.79%.
In short, single-stock ETFs are best left for experienced and active traders. For the majority of retail investors, the best course of action remains strategies with a long-term focus, like investing in index funds, reinvesting dividends and allotting compound interest the time it needs to work.
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