One of the key aspects of a sound portfolio is a diversified portfolio, and one of the most popular tools among investors to diversify a portfolio is through the use of Exchange-Traded Funds, or ETFs, generally due to their ease of access, low management fees, and tax efficiency. Traditionally, investors use ETFs to gain exposure to the broad market. But over the last two years there has been a rise in retail investors taking on concentrated bets in an attempt at scoring larger wins. Some participants would take this move one step further by leveraging their position, i.e., borrowing money, to amplify their returns by 1.5x, 2x, 3x, or more. Now, a new investment product in the U.S. is making these bets easier to access.
In July, several single-stock ETFs came to market that use leverage to amplify the daily returns of specific stocks. The ETFs aim to track the performance of a single specific name by 1.5x, 2x, or 3x. Though that daily performance also implies that losses could be magnified if an investor is on the wrong side of that bet. That is not the only risk on the table that would-be-investors need to be aware of.
One of those risks is that returns may not match what investors expect to see from the investment. For example, an ETF that seeks to return two times the daily performance of the specified stock may see similar results on a day-to-day basis but stretching out that investment period could leave investors with returns that are substantially different. Since historical returns for these leveraged single- stock ETFs are not yet available, let’s take a look at some of the leveraged broad market ETFs as an example. The image below shows the year-to-date returns (as of 09-02-22) of the Invesco QQQ ETF (QQQ) – which tracks the Nasdaq-100 index, ProShares UltraPro Short QQQ (SQQQ) – which seeks to return -3x the daily performance of the Nasdaq-100, and ProShares Short QQQ (PSQ) – which seeks to return -1x the daily performance of the Nasdaq-100. While PSQ closely resembles the returns of the QQQ – 25% gain for the -25% drop seen in the QQQ, the -3x version (SQQQ) should roughly be expected to return 75%, but instead is up slightly under 60%. Stretch this time frame out further, and the difference can significantly stray from the expected return.
Another risk is in the way these new products take on leverage. Single-stock ETFs utilize complex derivatives to take on leverage. Derivatives are financial contracts, set between two or more parties, that derive their value from an underlying asset(s) or benchmark. Sounds complex? Because they are. Additionally, these derivatives contracts inside the investment vehicle have a specific way they operate throughout the trading day. According to a segment on CNBC’s “ETF Edge,” products like these reset daily as they leverage and re-leverage each trading day. The segment goes on to explain that it is important for investors to understand how and when the product is making these movements because the product could potentially only resemble the intraday price movements but move differently outside of regular trading hours.
So, who are these new products for? I think it is fair to say that these new ETFs are not aimed at long-term investors and instead are meant for day traders. Those who understand the underlying assets of the products, that can monitor their portfolios day in and day out, can stomach the associated risk and are not using these in an account like one for a nest egg. That goes without saying that these products have garnered steam in the investment community and may continue to gain more attention. But just because an investment offers larger than normal returns does not always mean that the returns are always better. As with any investment, conducting research, exercising caution, and confirming suitability is very important.
Jose Rendon, AIF®
Senior Portfolio Administrator