Be Wary of Single-Stock ETFs, Warn SEC Commissioner, Education Head

Recommending the new product to retail investors without breaching fiduciary duties could be ‘challenging.’

Securities and Exchange Commissioner Caroline Crenshaw and Lori Schock, the SEC’s head of investor education and advocacy, have issued warnings that the newly created single-stock exchange-traded fund is a risky product for investors and could be for the markets as well.


Single-stock ETFs are a new exchange-traded investment that provide leveraged or inverse trading of a single stock, rather than multiple securities. They are intended to allow ordinary investors to take leveraged or short positions in a stock without having to actually short it. The main difference being that any investor could lose more than they invest when trading on margin, whereas a single-stock ETF investor can at most “only” lose everything they invested.


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In 2019, the SEC adopted a new rule under the Investment Company Act of 1940—Rule 6c-11—that created a framework allowing ETFs that meet certain criteria to come directly to market without first obtaining permission from the SEC.


“Nowhere in Rule 6c-11 is there a discussion of single-stock ETFs; there is no indication that the rule contemplated such products,” Crenshaw said in a statement. “However, single-stock ETFs are nonetheless coming to market under the auspices of that rule.”


Crenshaw warns that in addition to the risk that comes with leveraged and inverse exposure to a single stock, single-stock ETFs rebalance daily, which she said could cause returns to “diverge quite substantially” from the performance of the underlying stock, particularly if the ETFs are held for multiple days.


“In other words, investors’ returns over a longer period of time might be significantly lower than they would expect based on the performance of the underlying stock. These effects are likely to be especially pronounced in volatile markets,” Crenshaw said, adding that “in periods of market stress or volatility, leveraged and inverse products can act in unexpected ways and potentially contribute to broader systemic risks.”


She said that because of the risks associated with single-stock ETFS, it would likely be “challenging” for an investment professional to recommend them to retail investors while still honoring their fiduciary duties. Crenshaw also said she was “disappointed” that months after she and former Commissioner Allison Herren Lee called for improvements to the rules for exchange-traded products, the SEC still has not done so.


Schock said in a statement that for years the SEC’s Office of Investor Education and Advocacy, along with some commissioners and staff, have been warning that complex products present several risks to investors.


“These new products are no exception, as they provide levered and/or inverse exposure to a single security, which can present risks for investors,” said Schock. She said that holding a levered and/or inverse single-stock ETF is riskier than holding the underlying stock or a traditional ETF. She said single-stock ETFs aim to provide returns over extremely short time periods, sometimes no longer than a day, and that new risks can emerge for anyone who holds them for longer than that.


Schock added that “because levered single-stock ETFs in particular amplify the effect of price movements of the underlying individual stocks, investors holding these funds will experience even greater volatility and risk than investors who hold the underlying stock itself.”


Earlier in July, asset management firm AXS Investments launched eight single-stock ETFs that offer leveraged long and short daily exposure to Tesla, PayPal, Nike and Pfizer. The firm stated that its single-stock ETFs are “intended to be used as short-term vehicles,” and said in its risk disclosure that the funds are not appropriate for investors who do not intend to actively monitor and manage their portfolios.


“For periods longer than a single day, the funds will lose money if the underlying stock’s performance is flat,” the risk disclosure states, even warning that “an investor could lose the full principal value of his/her investment within a single day.”


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