Single-Stock ETFs Are On The Rise — Understand These Core Principles Before Investing

Single-stock exchange-traded funds (ETFs) are relatively new and invest in a single stock. These ETFs use derivatives contracts -- especially options -- to provide leveraged and inverse returns.

The GraniteShares 1.25x Long Tesla Daily ETF NASDAQ:TSL aims to provide 1.25 times the daily return of the famous household name stock Tesla Inc. NASDAQ:TSLA.

With this ETF, investors would earn 125% if Tesla were to increase by 100%. Some ETFs are designed to be inverse, meaning they perform the opposite way of the underlying stock.

For example, the Direxion Daily AMZN Bear 1X NASDAQ:AMZD seeks daily returns of 100% of the inverse (or opposite) performance of Amazon.com Inc. NASDAQ:AMZN.

However, these investments aren't for beginners and carry several underlying risks like time decay and higher expenses.

Higher Expenses

Options are the key reason that these ETFs offer magnified and inverse returns.

Because these ETFs are actively managed with personnel trading options on them, they carry higher fees. For example, the Direxion Daily AMZN Bear 1X has an expense ratio of 1.15%. 

This is much higher than the standard ETF expense ratio. For instance, the Vanguard Total Stock Market ETF NYSE:VTI ratio is a minimal 0.03%.

Aside from higher expense ratios, option premiums or the fees paid to enter the contract can be costly. One contract that provides access to 100 shares could be at least $500, which contributes to higher fund expenses.

Despite potential higher short-term returns, these significant expenses can cost you thousands over the long run.

Lack Diversification

Unlike typical ETFs or index funds, you don't have access to a basket of 100-plus securities in various sectors, which provides diversification with single-stock ETFs. Diversification is one of the key reasons legendary investor Warren Buffett recommends basic index fund ETFs to most investors.

With single-stock ETFs, you'd be tracking one main stock, which can be quite risky.

For example, Peloton Interactive Inc. NASDAQ:PTON was a favored stock during the COVID-19 pandemic but has lost 91% of its value since September 2021.

Single-stock ETFs carry this same risk and highly popular stocks, especially in tech and entertainment, can realize sudden significant losses.

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Designed For Short-Term Investing

Options are meant for short-term trades because of time decay. Simply put, an option loses value the closer it gets to its expiration date. Single-stock ETFs heavily use options, making them subject to losses resulting from time decay.

These ETFs rebalance every day so their prices mimic the underlying stock and multipliers (i.e 1x Amazon or minus 2x Google). 

This results in compounding risk because their returns won't be exactly in line with the stock and multipliers long term. Slight price differentials might not seem like much, but they can grow larger because of compounding.

Time decay and compounding risk are two major reasons most investors trade these ETFs intraday.

Single-Stock ETFs Offer Higher Returns With More Risk

Single-stock ETFs use options contracts to give investors magnified returns and hedge against falling stock prices. However, these aren't meant to be taken, likely because they lose value resulting from time decay, have higher fees than most passive ETFs and lack diversification.

Bryan Armour, director of passive strategies research at Morningstar Research Services, said, "The stated amount of leverage or inverse exposure is reset daily, meaning these are short-term vehicles that are not intended to be held over long periods."

Keep this and other risks in mind before investing in these new, popular ETFs.

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