By Randall Coleman, Portfolio Manager

Since their advent in the 1990s, Exchange Traded Funds, or ETFs, have become wildly popular and have grown in scope to account for a massive amount of tradeable global securities. By some estimates, the global market cap of all ETFs is north of $8 trillion, with seemingly endless growth. A quick Bloomberg screen counts 10,572 global ETFs, with a one-year flow into them of $1.1 trillion. Originally formulated for passive investors to gain exposure to a relatively narrow set of stocks—hotel stocks, or energy stocks, for example—at an extremely low expense, typically under 20 basis points, their issuers have reached new heights in creativity. 20 years ago, as a joke, I thought of the most ridiculous ETF possible, an ETF that contained a single stock. No diversification, no broad sector exposure, just a single stock with the issuer collecting a fee. Fast forward to today, and the SEC is set to approve such vehicles later this month, but with a twist. The single-stock ETFs will be leveraged with the intent to give investors double or triple the underlying stock’s daily performance. This type of ETF was originally created in Europe several years ago and they have attracted a lot of attention. US investors need to be aware and wary of them.

Let’s ask whether levered, single-stock ETFs deliver on their performance bogeys.

A quick look at the graph below, showing total return of Tesla stock, the 2x levered single stock ETF and the 3x levered version on the same stock clearly shows that any delivery of the stated objectives is very short term indeed. Over the trailing year period (April 6, 2021 – April 6, 2022), Tesla stock has risen 51.20%. The 2x levered product gained 61.65%, far short of the implied 2x of 102.40% and the 3x product gained 33.51%, more than 1000 basis points below what would be expected. The promise of double and triple performance is only approximated on daily or intraday performance, not long-term time periods.

In the short-term, measured by day, the expected performance is also absent. Take the first ten trading days in February, for example:

On only one day was the 2x-levered ETF’s performance close to the calculated value. For this Tesla example, it appears that return experience does not match up well with the purported goal of the levered single-stock ETFs.

These high-octane ETFs are the latest manifestation of the get-rich-quick mindset. This mentality is evident in the rise of Robinhood day traders who were enabled by home confinement during Covid lockdown. Single-stock levered ETFs are more fuel for these short-attention-span “investors.”

This is a curious dynamic indeed. From the SEC’s website (https://www.sec.gov/about.shtml), “The mission of the SEC is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. The SEC strives to promote a market environment that is worthy of the public’s trust.” Given a 2x levered ETF on a high volatility stock, it’s difficult to discern what “protection” the SEC is attempting to offer investors. Magnifying a high volatility stock’s daily return doesn’t seem to add “orderliness,” either. The SEC’s objective of facilitating capital formation in this regard would seem to benefit only the issuers, who collect fees.

ACM’s investment strategies are just about perfectly diametrically opposed to these new-fangled ETFs. Where they offer dopamine and adrenaline rushes to day traders, ACM’s strategies offer prudent, careful, diversified, sober management. Not get-rich-quick schemes. A primary goal of portfolio construction is to improve the risk/reward combination. These ETFs seem to move in the wrong direction, adding risk and subtracting return.

Innovation in financial products is a never-ending story with potentially useful and valuable investment vehicles produced. With a skeptical eye, investors are better able to separate the wheat from the chaff. Remember, in Las Vegas, who pays for the lights?

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

About the Author

Randall Coleman

Randall Coleman

Randall Coleman, CFA is a portfolio manager focused in international and small/mid cap securities. Before joining ACM, Randall was the co-manager of the Salient Dividend Signal Strategy® portfolios. Previously, Randall was a portfolio manager and analyst for Berkeley Capital Management....
About the Author

Categories

Archives