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. 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.”
Alex Morris, F/M Investments CEO and CIO, noted that there are many ideas 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.
He 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.
Morris cautioned that investors bear responsibility and a common mistake is approaching these products with a mindset of “just wanting to amplify a guaranteed win.” He stressed the 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 that approaches 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.
Akins cautioned that the market can only handle so much leverage, and the more that is built up, the more potential there is for a destabilizing impact. “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,” he said.
Morris argued that when multiple ETFs pursue the same strategy and there are not many counterparties to take the other side of the trade, “that’s where the destabilizing factor starts to enter in.” He noted that market makers and brokers providing leverage and exposure will adjust, and “we’re starting to see it” with some larger products in the market already.
The Securities and Exchange Commission (SEC) 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 on another booming area that uses derivatives: prediction markets ETFs. Morris said the SEC’s questions are appropriate and that the agency has a duty to assess how the industry has evolved—from passive, low-cost, tax-efficient products to a broader spectrum of offerings that use speculative approaches that did not exist decades ago.
Morris stressed that the ETF industry is unlikely to be the cause of a systemic market event, but he warned that the next external market shock could reveal vulnerabilities in leveraged single-stock products. “The market will keep going until something happens,” he 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.’”
“Right now, it is hard to stop that train, and the market is not necessarily trying,” Morris 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.”
