Debate over one-day-only ETFs highlights unfolding cultural shift

THE late Jack Bogle – father of the first index fund – famously loathed their exchange-traded offspring, warning that it only incentivises speculative trading among “fruit cakes, nut cases and lunatic fringe”. Fast forward to 2024, and critics warn a new generation of exchange-traded funds (ETFs) is designed to do exactly that.

Enter the high-octane arena of leveraged single-stock funds, which use derivatives to amplify returns on an individual company.

Naysayers argue that the funds encourage day trading at the risk of fierce underperformance if held for longer than just a couple of days. It takes under three days for the US$4.8 billion GraniteShares 2x Long NVDA Daily ETF (NVDL) – the largest single-stock fund – to see its entire portfolio turn over, Bloomberg Intelligence data shows.

Advocates say these ETFs are meeting a demand in the investment world among a community of highly engaged retail traders. US-listed single-stock funds now command about US$13.4 billion after the first set sail two years ago, according to Bloomberg Intelligence data.

The debate highlights a cultural shift unfolding in the nearly US$10 trillion US ETF arena. The structure was born in 1993 as a passive, index-tracking vehicle – a reputation that still endures today, even as record sums of cash are funnelled into actively managed ETFs. Yet, the reality is that the industry is increasingly pumping out products geared to satisfy the most speculative fantasies of retail and institutional traders alike.

“For people stuck in the 1990s and the 2000s, when ETFs were all about tracking an index fund, this stuff bums them out, but it’s an evolution of the technology,” said Eric Balchunas, Bloomberg Intelligence’s senior ETF analyst and the author of The Bogle Effect. “Bogle didn’t like that ETFs tempted you to trade, and he didn’t like the mutations and marketing. A leveraged, single-stock ETF has both of those in spades.”

The funds offer amped-up exposure only to a stock’s one-day return, given that the daily rebalance of the options book erodes returns over time.

The Europe-listed US$11 million GraniteShares 3x Long MicroStrategy Daily ETP (LMI3) is the ultimate example. While MicroStrategy itself is higher by more than 100 per cent this year, LMI3 has dropped nearly 82 per cent – despite offering leveraged long exposure to the stock. That dynamic holds on a one, three and six-month basis as well.

Napkin maths suggest that traders are following instructions. For example, the US$1.5 billion Direxion Daily TSLA Bull 2X Shares fund has an average trading volume of nearly US$303 million. Dividing that sum by the fund’s average market capitalisation of about US$1.1 billion produces a turnover rate of 28.2 per cent, meaning it takes about 3.5 days to completely flip its portfolio. That compares to about 185 days for the US$503 billion Vanguard S&P 500 ETF, which is popular among buy-and-hold investors.

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Such metrics can be viewed as a very rough proxy for a fund’s average holding period, according to Bloomberg Intelligence. While the frenzied turnover rate can be viewed as good news because that means the ETFs are being used as intended, there is likely a cohort of less sophisticated traders getting smoked, Morningstar’s Ben Johnson said.

“Inevitably, there are going to be unsuspecting victims of these products, for whatever reason – there aren’t adequate guard rails in place to prevent them from using them without adequate knowledge of how to,” said Johnson, the firm’s head of client solutions.

“Worst nightmare”

Single-stock ETFs launched into controversy in July 2022. While industry rule changes in 2019 and 2020 paved the way for such products to list, regulators were quick to deride them.

Securities and Exchange Commission chair Gary Gensler said the ETFs “present particular risk” just days before the first began trading. Commissioner Caroline Crenshaw went a step further, cautioning investment advisers about recommending these products to retail traders.

The consternation surrounding single-stock ETFs was reignited earlier this month with the launch of the Defiance Daily Target 1.75X Long MSTR ETF (MSTX), which seeks to provide daily leveraged returns on MicroStrategy. Given that the stock itself already boasts a 90-day volatility of about 97 per cent, the new offering likely ranks as the most volatile US-listed fund on the market.

“MSTX is probably even worse than Jack Bogle’s worst nightmare,” Johnson said. “Bogle could not have comprehended that.”

To GraniteShares chief executive Will Rhind, such criticisms amount to little more than patronising pearl-clutching. Rhind, who launched European single-stock ETFs in 2019 before venturing stateside, said that the rise of the self-directed trader is a “super-macro investing trend”.

“We’re trying to create products for that community, and that is a very different community from what a lot of the traditional asset-management industry focuses on,” Rhind said.

While cheaper than other means of accessing similar degrees of leverage, single-stock ETFs are noticeably more expensive than the rock-bottom fees that have come to define the industry.

For example, NVDL charges 1.15 per cent annually, compared to the average expense ratio of around 0.7 per cent for US-listed, actively managed equity ETFs. Since these ETFs are being held anywhere from a couple of hours to a couple of days, most investors in the fund likely are not forking over the entire 1.15 per cent fee, Bloomberg Intelligence’s Balchunas said.

While there is concern that such funds push individuals to day trade at the expense of investing, the optimistic take is that they scratch the itch before it spreads, he said.

“There is an argument to make that these single-stock leveraged ETFs are a by-product of the core of the portfolio getting a bit boring, and people are looking for a little action,” Balchunas said. “If it keeps their hands off the core, it could serve a purpose, in a behavioural way.” BLOOMBERG