Podcast: The Rise Of The Single-Stock ETF – Commodities/Derivatives/Stock Exchanges

Transcript:

Jennifer Choi: Hello, and thank you for joining us today
on this Ropes & Gray podcast. I’m Jennifer Choi, a counsel
and senior policy adviser in the Washington, D.C. office of Ropes
& Gray. Joining me today is my colleague in the asset
management practice group, Ed Baer, a counsel in the San Francisco
office. In this podcast, which is part of a series of podcasts on
ETF issues, we will discuss one of the hottest trends in the ETF
space—single-stock ETFs. Single-stock ETFs allow investors to
use leverage or make inverse bets on companies, such as Tesla,
Nvidia, PayPal and others. There are even some single-stock ETFs
designed to provide exposure to so-called “meme stocks.”
Ed, can you tell me about how these single-stock ETFs
work?

Ed Baer: Sure, Jennifer. Single-stock ETFs use leverage
to magnify or trade at the inverse of the daily performance of the
single-stock they track. For example, there are ETFs that seek to
deliver up to 2x the return (or 2x the inverse of the return) of
individual stocks, often widely-traded ultra-market-cap
stocks.

Jennifer Choi: So, these ETFs track some of the
largest and most liquid stocks in the market? Why would an investor
need to invest in an ETF (and pay a management fee) when she can
just invest directly in the company’s stock? What does a
single-stock ETF offer that investing in the underlying stock
can’t?

Ed Baer: Well, the short answer is increased
(or, in the case of inverse single-stock ETFs, decreased) exposure
to the daily returns of the individual stock (or, in the case of
inverse single-stock ETFs, the opportunity to benefit from
depreciation in the stock). The investment case for these ETFs, as
well as the risks and benefits, are similar to those of other
existing leveraged or inverse ETFs in delivering desired returns
over a specified period only, which is typically one day. Similar
to traditional index-based leveraged and inverse ETFs, these
single-stock ETFs use derivatives to seek to achieve their desired
returns.

Jennifer Choi: Okay, so unlike leveraged and
inverse ETFs that seek to deliver a leveraged or inverse return of
the diversified index, these products focus on a single-stock. If
held for more than one day, the returns can vary significantly from
the exposure because these ETFs reset the leverage daily. In
addition, because the returns of these funds are tied to the
returns of individual stocks, the volatility of the underlying
stocks will be magnified due to the leveraged or inverse nature of
the ETFs.

Ed Baer: That’s right. These are not
buy-and-hold vehicles. The issuers of these products have attempted
to make it clear that these are sophisticated investment tools
designed to provide active traders, who are focused on making very
short-term trading decisions and who have a strong directional view
on a certain stock, the opportunity to make tactical trading
decisions based on company news such as earnings announcements or
regulatory developments.

Jennifer Choi: Speaking of regulatory
developments, the SEC and FINRA have their eyes on these products.
Shortly before the first single-stock ETFs came to market, SEC
Commissioner Crenshaw warned “Because of the features of these
products and their associated risks, it would likely be challenging
for an investment professional to recommend such a product to a
retail investor while also honoring his or her fiduciary
obligations or obligations under the Regulation Best Interest.
However, retail investors can and do access leveraged and inverse
exchange-traded products through self-directed trading.” At
the same time, the Director of the Office of Investor Education and
Advocacy cautioned that “Holding a levered and/or inverse
single-stock ETF is not the same as holding the underlying stock, a
traditional ETF, or even a non-single-stock levered and/or inverse
ETF. It is riskier for several reasons.” She then went on to
talk about the short-term nature of the exposure and the lack of
diversification in underlying exposures.

And at a conference recently, senior SEC staffers noted that
Chair Gensler has asked the staff to focus on complex products such
as leveraged and inverse ETFs, including single-stock ETFs, so
there may be additional regulation forthcoming. We understand that
the Division of Investment Management is working with the Division
of Trading & Markets and the Division of Economic and Risk
Analysis to understand the market impact of single-stock ETFs.

Another concern of the SEC is that issuers looking to launch
single-stock ETFs on foreign stocks that don’t have to meet the
same financial reporting standards as a U.S.-listed company. The
SEC is concerned about American investors gaining access to foreign
companies that wouldn’t be able to access them directly.

Ed Baer: Exactly. While it’s unclear
whether the SEC can do anything to stop the launch of single-stock
ETFs on non-U.S. stocks, they’re definitely concerned that U.S.
investors could be harmed. Interestingly, one of the firms that
filed a registration statement for a series of single-stock ETFs on
non-U.S. stocks in early September withdrew the registration
statement for those ETFs about two weeks later. It is unclear
whether the withdrawal was voluntary or whether the SEC asked the
sponsor to withdraw the registration statement. I expect there will
be more to come on these products in the near future.

In addition to the SEC focus, FINRA’s recent Complex
Products proposal focused on an extremely broad list of
“complex products,” including leveraged and inverse ETFs.
This may result in additional sales practice restrictions or new
disclosure obligations. Unsurprisingly, the ETF industry reacted
very negatively to the FINRA proposal, especially the portion of
the proposal that suggested that self-directed investors might not
be permitted to invest in “complex products” like
leveraged and inverse ETFs.

Jennifer Choi: What I find curious is the
timing of the launch of these products in the U.S. Products like
these have existed in Europe for years, but they’ve only
recently found their way to the U.S. There are about two dozen of
these single-stock ETFs in the market already, and there are dozens
more in registration, including single-stock ETFs that track
non-U.S. securities. And all of these have launched since July. Why
now?

Ed Baer: For starters, the adoption of the ETF
Rule, as well as the Derivatives Rule, really opened things up. For
years, the SEC refused to permit new exemptive orders allowing
leveraged and inverse ETFs, so product innovation in this area was
stifled. The ETF Rule, when combined with the Derivatives Rule,
permits additional issuers to launch new leveraged and inverse
ETFs, including single-stock ETFs, so there are a number of issuers
that have entered the leveraged and inverse ETF market. At the same
time, I wouldn’t be surprised if these products are seeking to
take advantage of some of the trends related to meme stocks and the
“gamification” of trading, two areas the SEC is
definitely focused on. One thing I’ve noticed about
single-stock ETFs is that the amount of targeted leveraged or
inverse return tops out at 2x leverage or -2x leverage. For years,
there have been 3x leveraged or inverse ETFs. Why aren’t there
3x leveraged or inverse single-stock ETFs?

Jennifer Choi: What it boils down to is how
much leverage can you achieve consistent with the 40 Act’s
Derivatives Rule? Under the new Derivatives Rule, funds have to
comply with one of two different “value at risk” or
“VaR” tests—the relative VaR test or the absolute
VaR test. A fund will satisfy the relative VaR test if its
portfolio VaR doesn’t exceed 200% of the VaR of its
“designated reference portfolio” or “DRP.” A
fund that doesn’t have a DRP will satisfy the absolute VaR test
if its portfolio VaR doesn’t exceed 20% of the value of the
fund’s net assets. As a result, 2x leverage or -2x inverse
leverage is the maximum leveraged or inverse exposure attainable by
open-end funds under the Derivatives Rule. However, at the time the
Derivatives Rule was adopted, the SEC grandfathered in existing
index-based 3x and -3x leveraged and inverse ETFs.

Ed Baer: That makes sense, but not all of these
single-stock ETFs seek up to 2x leveraged or 2x inverse leveraged
exposure. Instead, issuers of single-stock ETFs appear to have
concluded, based on the volatility of the underlying stocks, that
less than the maximum permitted leveraged or inverse exposure is
desirable, so there are products out there that establish lower
leveraged and inverse targets (such as 1.5x leveraged or 1.5x
inverse leverage). I think the lesson for investors is that if you
are thinking about purchasing a single-stock ETF, understand what
the precise exposure of the ETF will be, and do not view the
single-stock ETF as a buy-and-hold investment.

Jennifer Choi: That’s right. These things
can be risky and even more volatile than the underlying stocks, so
invest carefully.

Well, that brings us to the end of the podcast. Ed and I want to
thank you all for joining us on this discussion of single-stock
ETFs. For more information on the topics that we’ve discussed
or other topics of interest to asset managers and ETF sponsors,
please visit our website at www.ropesgray.com, where we have links to some
additional material regarding these topics. To help you better
understand the current ETF landscape, we’ll be issuing several
additional podcasts designed to provide a greater depth of analysis
on important and timely ETF issues. If you have any questions
regarding the topics we have addressed or anything else, please
don’t hesitate to get in touch with one of us or whomever you
have a working relationship with at Ropes & Gray. You can also
subscribe and listen to the series of podcasts wherever you
regularly listen to podcasts, including on Apple, Google and Spotify. Thank you again for listening.

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