Next week, several exchange-traded fund companies plan to hit the market with the latest ETFs offering a way to add leverage to bets on single stocks, in this case, on the South Korean chip giant SK Hynix, which began trading in the U.S. on Friday.
The development should come as no surprise: similar SK Hynix portfolios are already among the most popular ETF trades in South Korea’s market. And there is nothing inherently wrong with the planned SK Hynix ETFs coming to the U.S. from companies including GraniteShares and ProShares. Demand for the stock that has effectively been off the radar of most U.S. investors without a domestic listing is “enormous,” the company’s chairman told CNBC.
Many existing single-stock ETFs trading on the biggest tech companies in the U.S. operate normally, day in and day out, covering all the Magnificent 7 tech companies, from Nvidia to Apple and Tesla, and most recently, SpaceX, which fell below its first day of trading open price earlier this week and is now down roughly 8% since its IPO, not uncommon for a new issue.
As long as investors understand the risks associated with using leverage, the ETFs keep getting launched because the demand keeps growing for these kinds of trades. But for an ETF market that boomed over three decades primarily on low-cost, tax-efficient, core index fund investments covering broad markets like the S&P 500, the debut of one more ETF using leverage to juice returns for investors is a sign of a vastly changed industry, and one that ETF experts say merits more attention from fund sponsors, investors, and regulators.
Leverage in the ETF market is, according to ETF Action founding partner Mike Akins, “getting a little carried away.”
“It’s not that the products are bad,” Akins said on this week’s “ETF Edge.”
“The overwhelming number of ETFs that come to market do what they say they will do, whether it is 2x a memory stock or inverse it. However, sometimes what it says it is going to do is not great for the overall ecosystem of the market. There were certain things not meant to be inside a regulated product,” he added.
Alex Morris, F/M Investments CEO and CIO, says there are many interesting ideas that his ETF company decided not to bring to market for reasons related to limited liquidity, as well as use of leverage and options, and concerns that it would be difficult to properly communicate risks to investors. “Sometimes, what investors want should be had in a different format. If what you really want is lots of leverage, the futures market is probably the place for you to be, and the options market, where you can get not just 2x, 3x … but 10x to 100x,” he said.
But Morris added that there is a compelling reason for more of these trades to be taking place within the ETF wrapper. The amount of paperwork and disclosures related to underlying leverage in futures and options markets is much more burdensome for investors than trading an ETF.
And Akins said the goal of ETFs is to make it simpler to trade, whether it is 500 stocks or 25 companies across the world, or a single one. “For an everyday investor, if I want 2x leverage on a stock that I think is about to report blowout earnings, an ETF is a safer way to do it than a margin account,” he said.
Morris said investors bear some responsibility, and a big mistake investors make is having a mindset of “just wanting to amplify a guaranteed win.”
Investors also need to understand how single-stock ETFs work as trading vehicles, specifically, how losses can accumulate quickly. “With traditional leverage, you get margin calls. But when you are long-only 2x into a name, you could get an NAV [net asset value] that approach zero if you buy and don’t pay attention. You can find a stock up, but [your] position is net down. That’s an education issue,” Morris said.
“Single stocks are the obvious example where it can get out of hand very quickly,” Akins said.
“The market can only handle so much leverage, and the more that gets built up out there, there needs to be a stop. I do think there is probably a breaking point with certain types of ETFs, stocks trying to go into levered wrappers,” he said.
Market makers and brokers that provide the leverage and exposures will step back, Akins said, and he added if you look at some of the larger products in the market right now, “we’re starting to see it.”
Both the cost to get leverage and risk to the counterparty of the leverage has “gotten so extreme,” he said. “The market can push back to a certain degree, but regulators have a responsibility to not create a scenario where checks and balances don’t exist to keep it from getting the market too levered,” Akins said.
Morris said when there are five, six, or even a dozen ETFs all doing the same thing, and investors all want to be on the same side of the trade and there are not many parties to take the counter-trade, “that’s where the destabilizing factor starts to enter in.”
The Securities and Exchange Commission announced on June 30 a new request for comment period on ETF innovation and “novel investment strategies,” with many expecting focus not necessarily on single-stock ETFs but another booming area of the market that uses derivatives: prediction markets ETFs.
Morris said during the podcast portion of this week’s “ETF Edge” that while more investing concepts being brought to market in an ETF wrapper can benefit many investors by way of the scale of assets reducing trading costs and complexity, the questions the SEC is starting to ask are the right ones. “How did we get here? … What is the right way to tackle an industry that went from passive, low-cost, tax-efficient products to an entire spectrum, and new ones that use speculation vehicles that didn’t exist legally five years ago, let alone 30 years ago.”
“The SEC has a duty to say, ‘When does this end? What is next interesting thing we might invent?'”
And the market alone will not stop to answer that question ahead of potential harm to investors. “The market will keep going until something happens,” Morris said. “And the SEC’s job is to say, ‘How do we stop that something bad from happening and taking down that 35 years-plus history of what has been a great financial success.”
Morris stressed that he does not believe ETFs will be the cause of a systemic event in the market, but when it comes to the forces that may end the current boom in more risky ETFs, he added, “the next external market event, not-ETF specific, will help us find it quite quickly.”
Right now, “it is hard to stop that train, and [the market] is not necessarily trying,” he said. “We’re certainly going to see more of the leveraged single-this, single-that products. They’ve been too successful for people to stop. The raw capital says they should keep going, and they will,” Morris said.
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