Single Stock ETFs

I want to talk about this opinion piece over at Investment Executive titled “Single-Stock ETFs highlight a gap between conservative advisors and FIRE investors.”

The writer of the piece is Karl Cheong, executive vice-president and head of ETFs at Ninepoint Partners LP. Ninepoint “manages innovative investment solutions that offer investors the benefits of better diversification.”

I’m going to summarize the piece in a few sentences before explaining why I think single-stock ETFs, like most innovative investment products, should be avoided by long-term investors.

Investing is changing, according to Cheong. Income, simplicity, and familiarity are desired more than ever, especially by younger investors. Yield-enhanced, leveraged single-stock ETFs, along with commission-free online trading provides those investors easy access to investment products that have often been considered too exotic for retail investors.

As a result, advisors are being careful in adding them to client portfolios. They’re using single-stock ETFs as tactical plays, if at all.

Cheong says the creators of these products must continue innovating. Their product design must be better (more investment options), they need to lower product fees and scale, and they need to ensure the income these products provide is reliable and transparent.

He ends the piece saying these new investment products won’t replace diversified portfolios but instead show how investors prefer investments that focus on “precision over breadth, control over delegation and action over restraint.” I’ll come back to that statement at the end.

I purposely italicized the word products earlier because the investment vehicles Cheong is describing are not solutions. They’re products. And they’re products that any serious investor should avoid for three reasons.

First, these products are worse than they look. Covered calls have their place, and that place is range-bound markets. But they’re needless for long-term investors. You cap your upside and do nothing to protect your downside. Ben Felix has several videos (see here, here, here, and here) looking at these products from an evidence-based perspective. I look at it practically: it’s a product that caps how much you can make while doing nothing to limit your downside.

“Oh, but you get income in return,” is the rebuttal. But investors should care about total returns. The focus on solely how much income an investment may pay is a mistake.

Let me use real estate as an example:

“Hey, I bought a house for a million bucks a few years ago. I rent it out for $5,000/m. That $5,000 is all mine. The tenants aren’t ever going to move out. “

“Have you looked at that neighbourhood lately? It’s in decline. Your house is only worth a quarter of a million now. “

“I don’t care. I’m getting my $5,000/m forever. “

“Your house has lost three quarters of a million in value...”

Focus on the underlying investment and its total return. Not just how much income it pays.

Second, the marketing is clean, but the products aren’t. Simple and easy aren’t the same thing. These single-stock ETFs are easy. They aren’t simple.

“I can buy shares of TD bank with 25% leverage, and I get even more of a dividend than TD pays because of covered calls.”

It’s not that simple. Ninepoint themselves say these products “work best in flat or range-bound markets." Markets are volatile, and individual stocks are even more volatile.

Third, leverage is leverage. It doesn't matter if you’re using your credit card, line of credit, margin, options, or a single-stock ETF to invest. Leverage feels good when things are going well but hurts a lot when things aren’t. And loss aversion is real. Good times feel good and for a short time. Bad times feel like hell for a long time.

If you put $100,000 into something like the leveraged TD single-stock ETF and TD shares drop 10%, you’re on the hook for a $12,500 loss. Not just a $10,000 loss.

The rebuttal to that is “but you get income from the covered call.” And that’s true. But the covered call limits your upside when TD shares go on a tear. The Ben Felix videos above articulate this dynamic beautifully.

There are no shortcuts in investing. There are only trade-offs. Risk and reward are partners. You don’t get one without the other. There will always be investment products pitched to you that sound like shortcuts. They aren’t. They just juice returns on the way up and losses on the way down.

I said I’d come back to this next part. Cheong ends by saying single-stock and leverage ETFs “reflect a changing investor mindset: one that favours precision over breadth, control over delegation and action over restraint.”

That sentence deserves scrutiny.

Delegating to a professional that helps investors stay diversified and restrain themselves whenever markets get stupid (either up or down) is one of the most valuable parts of the advisor/client relationship.

The changing investor mindset Cheong mentions is a mindset finance professionals need to fight back against. And that’s because it fuels a destructive fire.