Investors awaiting ETFs with as few stocks as possible are in luck: Single stock ETFs arrived on the scene, providing leveraged or inverse exposure to individual names such as Tesla, Nvidia, Nike, PayPal, and Pfizer.
While some investors may want greater exposure to their favorite companies or to express bearish views on their least favorites, single stock ETFs may be a case of the wrong thing done for the wrong reason. Single stocks already have a wide range of outcomes, which is amplified when paired with leverage.
While the novelty here is the focus on single stocks, leverage brings the meat of the story. Leverage magnifies returns, which in turn amplifies volatility.
A simple example highlights how this could impact an investor’s experience. Suppose you bought $100 of your favorite stock. If it declines by 10% that day and then rebounds by 10% the next, your investment drops to $90 the first day and ends up at $99 the second.
Now suppose you had doubled your exposure via leverage. The same 10% decline and rebound in the stock would drop your investment to $80 before bringing it back-up to $96. The 2x exposure didn’t merely double, but rather quadrupled your loss.
It’s one thing to amplify broad market level volatility; it’s another thing to amplify single stock volatility. The average annualized median monthly standard deviation of individual U.S. stocks is around 38% historically, about double the S&P 500’s historical level of volatility at 19%. A one standard deviation decline of 38% would translate to a 76% loss at 2x leverage.
Single stock ETFs eschew a fundamental investment principle—diversification. Research tells us investors cannot reliably predict which stocks will outperform the market. Furthermore, the median stock underperforms the market.
And while inverse single stock ETFs allow investors to express viewpoints or hedge out human capital exposure by cutting exposure to certain stocks, separately managed accounts provide a more robust platform for employing such preferences.
Staking outsized positions on individual stocks could mean neglecting to capture the premiums, missing out on top performers as they emerge, and failing to fully take advantage of the benefits of diversification.
Wes Crill is head of investment strategists and vice president at Dimensional Fund Advisors. Brian Ting is a researcher at Dimensional Fund Advisors.