Loyola University Chicago School of Law, JD 2023
While Exchange-Traded Funds (ETFs) were introduced in the early 1990’s, the investment product skyrocketed in popularity throughout the 2000’s. In fact, only one ETF existed in 1993 before the market subsequently expanded to 102 funds in 2002, and then to 1,000 funds by 2009. There currently exists more than 7,602 ETFs globally, and their popularity among investors has prompted the creation of numerous other Exchange-Traded Products (ETPs). While ETFs are the most prominent form of ETPs, fund issuers have introduced a myriad of products that vary in terms of volatility, complexity, and investor suitability. Hence, regulators and financial professionals have continued to warn the investing public of the risks involved with purchasing complex ETPs, such as single-stock ETFs, without sufficiently understanding how the products operate.
Background on ETPs and single-stock ETFs
ETPs encompass a broad range of investment products, including ETFs, in which the return on investment is directly correlated to the performance of an underlying security or financial index. In other words, ETP pricing is dependent on the day-to-day performance of the underlying security or financial index that the product is tracking. Therefore, similar to stocks, ETPs are traded daily on domestic and international exchanges where investors are permitted to analyze the performance of the ETPs as well as the underlying investment. Ease of access to information and online trading platforms have encouraged individuals and retail investors to regularly invest in various forms of ETPs, even as the products grow more complex and sensitive to volatility. The Securities and Exchange Commission (SEC) has long served as the primary regulator responsible for monitoring the everchanging ETP market to ensure that investors receive adequate information and disclosures as to the products they are pursuing.
A new type of ETP, known as single-stock ETFs, are making headlines and providing regulators with yet another complex product to monitor as retail investors may be prone to misunderstanding the purpose and function of the investment. ETFs are typically comprised of a basket of securities or investments within one financial index or market sector, which enables investors to diversify their investment portfolio and often reduce potential volatility or the risk of loss. However, single-stock ETFs only track the performance of one individual stock, which increases the volatility of the investment in comparison to other run-of-the-mill ETFs. Furthermore, many single-stock ETFs are leveraged ETFs, which amplify the returns of the underlying stock inevitably increasing the investment’s volatility. For instance, a leveraged long single-stock ETF, such as AXS 2X NKE Bull Daily ETF (NKEL), targets a multiple of Nike stock. In other words, if Nike share prices increase by 4% on a particular trading day, then the ETF will rise by 8%. However, if Nike stock decreases by 4%, then the ETF will fall by 8%. Some of these leveraged ETFs track underlying securities at a 3:1 or even a 4:1 ratio, and experts have warned individual investors regarding the dangers of holding these products for more than one trading day. In essence, single-stock ETFs enable retail investors to exponentially increase the volatility of their portfolios without adequately understanding the risks associated with leveraged ETPs; the disconnect has prompted regulators to step in.
Regulators warn investors
Both federal and state regulators have begun to scrutinize single-stock ETFs over their potential to result in substantial trading losses for retail investors who may not understand how the product operates. The U.S. Securities and Exchange Commission (SEC) recently released a statement on single-stock ETFs in an attempt to warn investors of the potential risks associated with investing in these types of complex, leveraged ETFs. The statement indicates that many single-stock ETFs will be permitted to enter the market pursuant to Rule 6c-11without first obtaining SEC permission. Rule 6c-11, which was promulgated in 2019, was designed to permit ETFs that meet certain conditions to have ease of access to the trading markets; however, the rule does not directly address single-stock ETFs, which has raised concerns from regulators. Furthermore, similar to most leveraged and inverse ETFs, single-stock ETFs undergo a rebalancing procedure on a daily basis. In other words, if an investor holds a single-stock ETF for multiple days, the daily rebalancing protocols could result in returns that substantially deviate from the returns generated by one underlying stock, which may cause further investor confusion.
The statement additionally notes that it would be difficult for a financial professional to recommend single-stock ETFs to a retail investor and uphold their fiduciary obligations because of the product’s volatile nature and its associated risks. Nevertheless, the statement concluded by addressing the elephant in the room, which is the reality that individual investors have unlimited access to leveraged, complex ETPs via self-directed online trading. While the SEC typically regulates the fiduciary obligations of financial professionals as well as the ETPs that enter the trading markets, the agency has little control over how retail investors allocate their funds or whether retail investors adequately understand the risks associated with certain ETPs. Hence, the statement recommends that retail investors defer to options contracts and other derivatives as opposed to single-stock ETFs to obtain leveraged exposure to one underlying stock.
State regulators, such as the Massachusetts Securities Division, have also launched initiatives to intensely scrutinize the newly offered single-stock ETFs. William Galvin, Massachusetts’ head securities regulator, announced an upcoming sweep of single-stock ETFs offered by broker-dealers registered in Massachusetts. In a regulatory sweep, such as the one instituted by Galvin, the agency will send a letter to each of the targeted firms requesting further information as to the firm’s offerings, promotional efforts, and client communications. In this particular sweep, Massachusetts securities regulators will be reviewing single-stock ETF offerings in the state “to ensure that broker-dealers are not recommending them to retail investors for whom they would be unsuitable,” according to Galvin. Galvin noted that single-stock ETFs should “under no circumstances” be utilized as a long-term investment vehicle. “For nearly all Main Street investors, there is no difference between investing your money in single-stock ETFs and gambling with that money at a casino,” according to Galvin.
Next steps for the SEC
While purchasing a single-stock ETF may not directly equate to feeding a slot machine, the heightened volatility associated with leveraged ETPs will cause problems for retail investors who lack an understanding of these products. The prevalence of online trading platforms will only add to the challenge of regulating single-stock ETFs as retail investors have unlimited access to these products, which could potentially expose thousands of investors to substantial volatility whether they know it or not. While the SEC ultimately cannot control how investors allocate their funds across the market, the agency will be tasked with regulating single-stock ETFs to protect investors. The first step will require the SEC to revise its rules pertaining to complex ETPs and design an updated regulatory framework that retroactively addresses newer versions of ETPs, such as single-stock ETFs, even if the ETP is not mentioned in the framework by name. An updated regulatory framework will permit the SEC to better evaluate complex ETPs on a case-by-case basis to determine whether investors are adequately protected. Additionally, the SEC possesses rulemaking authority under the Securities Exchange Act of 1934 as well as the Investment Company Act of 1940, which permits the agency to regulate single-stock ETFs under the scope of public interest and investor protection.