Stock Market Insights: Leveraged single-stock ETFs explained, high risk, high reward or just wealth destroyers?

Dr. Richard Baker, AIF®, is the CEO and executive wealth advisor at Fervent Wealth Management.

In my hometown, we have a railroad trestle that goes over the James River. One late winter night, after snow sledding, my buddy and I walked across the snow-covered trestle in pitch dark. It wasn’t one of our brightest moves; it was a lose-lose with not much upside. That also pretty much describes the new leveraged single-stock ETFs.

In the last few years, we were introduced to some new investment products, such as digital currencies, fractional ownership platforms, ESG funds (Environmental, Social and Governance) and direct indexing, but none are as scary as leveraged single-stock ETFs.

Leveraged single-stock ETFs use derivative contracts (borrowed money) to magnify the return of a single stock. Leveraged funds, which track stock indexes, have been around for a few years, but the high-risk leveraged single-stock ETF hit the markets in 2022. These new ETF variations offer to double or even triple the value of the underlying stock and are off the charts in terms of risk.

These single-stock varieties have become popular among investors who tend to be gamblers. They have the potential for high returns but also huge losses. Here’s how they work. If you bought the two-times-long Microsoft ETF and Microsoft went up 5% tomorrow, your ETF would gain 10%. The catch is that those same numbers apply to the downside. If Microsoft falls 10%, your ETF will be down 20% for the day. These products are designed to track the performance of their underlying asset over a single day, and if an investor holds for a longer period, it could do much worse than the actual stock it is tracking.

When the market goes up, these do great, but when it is down, they drop fast. When digital currencies and big tech companies were going higher and higher, these types of ETFs built a big fan base, but now volatility has entered the market, those fans are realizing the power of negative multiplication. Over the long period, these types of investments often lose money no matter what, even if the stock it trails goes up. The Wall Street Journal calls them “wealth destroyers.”

Many large brokerages are blocking their clients' access to these products, but that isn’t stopping companies from issuing more of them. There are over 700 leveraged single-stock ETFs on the market, and about 200 of those were launched this year. Another 27 new single stock ETFs filed paperwork last week, including one that would be the first 5x fund. Meaning, if that stock dropped 20% the investor would lose 100% of their investment. They wouldn’t be releasing them if they didn’t have customers for them. Which goes to say, there is a sucker born every day.

I highly recommend that most investors steer clear of these types of funds unless they are highly skilled investors. Just because something is popular doesn’t mean it doesn’t have pitfalls. I suspect these will go down the same path as indexed annuities, a lawsuit waiting to happen. All in all, they just aren’t worth the risk.

My buddy and I crossed the railroad trestle and back again safely, but we vowed never to do it again. We were terrified when we heard the river rushing under us, 70 feet below. We took a huge risk and got away with it. Investors shouldn’t do the same.

Have a blessed week!

www.FerventWM.com 

Securities and advisory services offered through LPL Financial, a registered investment advisor, Member FINRA/SIPC.

Opinions voiced above are for general information only and not intended as specific advice or recommendations for any person. All performance cited is historical abd is no guarantee of future results. All indices are unmanaged and may not be invested directly.

All investing involves risk, including loss of principal. No strategy assures success or protects against loss.

The economic forecast outlined in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Fervent Wealth Management is a financial management and services entity in Springfield, Missouri.