SEC approves single-stock leveraged ETFs

A top ETF headline recently was the Securities & Exchange Commission's (SEC) approval of single-stock leveraged exchange-traded funds (LETFs) for the U.S. market, managed by AXS Investments. Previously, only 2x and 3x (grandfathered in) LETFs of indexes existed. Some tracked broad indexes, while more volatile ones tracked sector or thematic indexes. 

The arrival of single-stock leveraged ETFs in the U.S. changes the ETF landscape significantly. These products have numerous uses and will likely attract high inflows from retail investors traditionally limited to margin or options. Let's examine the implications in-depth and discuss candidly how this may play out. 

What is a leveraged ETF?

A LETF is a financial instrument that offers magnified exposure to the movements of the underlying asset, which can be stocks, bonds, or even commodities. LETFs use derivatives called swaps to achieve daily resetting 2x or even 3x leverage, which can also be inverse (opposite). 

The important thing to note here is the daily reset. LETFs reset their swaps daily, so the leverage target is accurate only for a single day. For example, if the S&P 500 went up 3% in a day, a 2x LETF tracking it would go up 6% that day. However, the math of how compounding and geometric returns work causes their long-term performance to drift significantly. 

In choppy markets, volatility decay from up and down movements can also cause drags on long-term performance, especially for LETFs with underlying assets that do not have a positive expected return (VIX futures, commodities). This problem is especially acute for inverse ETFs, which generally trend towards zero over time and require frequent reverse splits to maintain their share price. 

LETFs are also expensive. Many LETFs charge more than 0.95% annually in expense ratios, compared to the low 0.03% some vanilla index funds have. Many LETFs also have a hidden fee in the form of the cost of borrowing incurred by the swaps they derive leverage from. Overall, they're not intended for long-term holds compared to regular ETFs. 

Benefits of leveraged ETFs

Leveraged ETFs do have their uses. I argue that their risk profile is arguably less than an investor seeking leverage using other instruments / methods, such as:

1. Margin: the risk of margin calls and interest rates is always prevalent and difficult for even experienced investors to manage (just ask Long-Term Capital Management and Bill Hwang). 
2. Options: Call and put options require complex knowledge of volatility and a certain degree of market timing due to expiration dates. 
3. Futures: Futures once again require the use of a margin account and strong technical knowledge, and unless you're using E-Minis, impose relatively high capital requirements.

LETFs have none of the above and most importantly, are risk limited. Investors cannot owe more than what they invested by buying an LETF. The worst-case scenario is the LETF goes to zero. That being said, they are still highly volatile investments and unsuitable for all but the most risk-tolerant and knowledgeable investors. 

Single-stock leveraged ETFs

Single stock LETFs are nothing new. The European market has traded these products since 2018, with fund managers like Leverage Shares providing a suite of ETFs tracking stocks like Tesla (TSLA), NVIDIA (NVDA), and Amazon (AMZN). Investors have been using these for day and swing-trading purposes for a while now. 

My main concern about leveraged single-stock ETFs is the possibility of fund delisting – the risk of the LETF suffering a catastrophic intra-day or overnight drop in price, leading to huge outflows that deplete assets under management (AUM). This happened with an inverse leveraged VIX exchange-traded note (ETN) in 2018 (otherwise known as the "Volmageddon" event).

The main reason behind this is a lack of circuit breakers. For instance, consider the ProShares UltraPro S&P 500 ETF (UPRO) a highly popular LETF offering 3x daily resetting leveraged exposure to the S&P 500 Index. The chances of this fund delisting are much lower than a single-stock LETF due to circuit breakers. This is a mechanism that halts trading after a 7%, 13%, and 20% drop in the index intra-day. There is a risk of the index gapping down at the start of trading or after hours, but that is still small. 

Not so for single stocks. Consider all the examples of stocks that tanked 10%, 20%, or even 30% during pre or aftermarket trading following a terrible earnings report or scandal. An investor in an LETF tracking said stock would face massive losses, or outright closure and liquidation of the LETF should a large enough drop occur (rare, but not unheard of). Case in point, even non-leveraged Russian equity ETFs were delisted lately due to a massive drop in the underlying. 

The final word on LETFs

I don't think these products are the "doomsday" devices other pundits are making them out to be, but there's no denying that they are incredibly, if not excessively, risky. In my opinion, the best use for a LETF is as an alternative to margin, options, or futures for day or swing-trading. Setting proper stop losses, having an exit strategy, and not risking too much on one trade is probably the best way to use them. As a long term-hold, definitely not so. You're combining the idiosyncratic risks of holding a single stock with the magnified exposure of leverage, which is a dangerous combination.