Investors have been reaping significant gains from popular tech stocks like Nvidia and the Magnificent 7. However, for traders looking to maximize their returns, single-stock exchange-traded funds (ETFs) offer a way to potentially achieve even higher profits by following the performance of these top stocks. These funds, which aim to provide double the return of their target stock, entice traders with the promise of amplified gains.
Let’s explore how single-stock ETFs function, the potential earnings they offer, and the associated risks.
Understanding Single-Stock ETFs and Potential Earnings
Unlike traditional funds that hold a diversified portfolio, single-stock ETFs focus solely on one stock. These funds offer investors the opportunity to magnify the returns of the target stock, potentially yielding higher profits compared to direct stock ownership.
There are three main types of single-stock ETFs:
- Leveraged Funds: These funds leverage borrowed money to invest in the target stock, aiming to provide investors with up to two times the daily return of the stock. For example, if the target stock rises by 10%, a 2x ETF would be expected to increase by approximately 20% on that day.
- Inverse Funds: Inverse funds allow investors to profit from a stock’s decline by short-selling it. When the target stock decreases in value, the ETF actually rises. Some funds may utilize leverage to amplify this return, potentially earning up to two times the inverse of the stock’s daily movement.
- Dividend Funds: These funds utilize options to generate dividend income from stocks that may not pay dividends. By employing covered calls (selling call options on a stock), these funds generate income that is distributed to investors.
Leveraged funds, in particular, tend to attract significant interest from investors as they enhance the returns of already high-performing stocks. Investors may be drawn to the idea of achieving even greater returns than holding the stock directly.
For instance, while Nvidia saw a remarkable 159% increase year-to-date as of July 15, the Direxion Daily NVDA Bull 2X Shares fund (NVDU) surged by 329% during the same period, showcasing the potential of double-leveraged funds.
It’s important to note that single-stock funds come with substantial fees. Typically, these funds have an expense ratio exceeding 1%, equating to around $100 annually for every $10,000 invested. In contrast, top index funds usually charge less than 0.1%, or $10 annually.
How Single-Stock ETFs Operate
As of May 2024, approximately 60 single-stock ETFs are available in the market, with this number steadily increasing due to growing investor interest in potential high returns. These funds are commonly based on popular, high-volatility stocks like Tesla and Nvidia, along with other tech giants such as Apple, Microsoft, Amazon, Alphabet, and Meta Platforms.
While these ETFs predominantly focus on well-known stocks, there is a trend towards introducing single-stock ETFs for meme stocks like AMC Entertainment and GameStop. These funds cater to the heightened interest surrounding these speculative stocks.
Leveraged funds offer the highest return potential by borrowing money to purchase the target stock, providing up to two times exposure to its performance. However, these funds are designed to track daily stock returns and are not intended for long-term holding. Daily rebalancing is conducted to maintain the appropriate leverage level, which can result in significant tracking errors.
On the other hand, dividend funds utilize call options to generate income from stocks without dividends, with the fund distributing this income to investors. While this strategy can be effective in stable or moderately rising markets, it may underperform during periods of significant stock price surges.
Understanding the type of single-stock fund you are investing in and the expected returns is crucial. These ETFs can be purchased through leading stock trading brokers, with most online brokers offering commission-free trades on ETFs.
Risks Associated with Single-Stock ETFs
Investing in single-stock funds carries risks similar to those of individual stocks, with additional risks stemming from the fund’s structure:
- Single Stock Reliance: Just like investing in a single stock, purchasing a single-stock ETF means your investment is solely dependent on that particular company. Any downturn in the stock will directly impact the fund without the diversification benefits of holding multiple investments.
- Increased Volatility: Leveraged funds amplify volatility, making them even more volatile than the underlying stocks. Investors must be prepared for heightened fluctuations when investing in these funds.
- High Expense Ratios: Single-stock funds are among the costlier ETF options, typically charging expense ratios of 1% or higher. This translates to approximately $100 per year for every $10,000 invested, contrasting with S&P 500 index-based funds that may charge around 0.03%.
- Limited Upside on Income Funds: Dividend funds that sell call options can restrict potential gains, especially during stock price surges. While these funds provide downside protection, they may significantly underperform in strong market uptrends.
- Leveraged Losses: The leverage in these funds magnifies losses, making it challenging to recover from downturns. For example, a 20% decline in a stock would require a 25% increase to break even, while a 2x leveraged fund would need a 40% gain to recover, significantly more than double the stock’s loss.
- Short-Term Focus: Leveraged funds are designed for short-term trading rather than long-term investment, emphasizing enhanced exposure to daily stock movements.
Final Thoughts
While single-stock ETFs have the potential to deliver substantial returns, particularly during periods of stock price surges, they are best suited for investors who understand the risks involved. These funds excel when the target stock is performing well, but can experience significant challenges during downturns.
Editorial Disclaimer: It is recommended that all investors conduct thorough research into investment strategies before making any investment decisions. Additionally, past performance of investment products does not guarantee future price appreciation.