Amongst the more adventurous holiday gifts in December 2022 would have been an investment in one of the first single-stock exchange-traded funds ("ETFs") to launch in Canada. Five single-stock ETFs launched in December 2022 providing exposure to Google, Amazon, Apple, Tesla, and Berkshire Hathaway.1
What is a Single-Stock ETF?
A single-stock ETF is ostensibly an ETF that invests in a single-stock. Single-stock ETFs combine the individual stock-picking process with leverage. The leverage position of single-stock ETFs allows for a heightened profit (or indeed loss) from an investment in single-stock ETFs vs. individual stock investing. For example, a single-stock ETF with 2x leverage doubles gains (and losses). A 5% gain for the underlying stock turns into a 10% gain for the 2x single-stock ETF.
US/Canada Distinction
Single-stock ETFs originated in Europe – and arrived in the US in the summer of 2022– but the US single-stock ETFs differ from those currently offered in Canada.
US single-stock ETFs offer investors access to short-selling and heightened leverage (ranging from 1.5x to 3x exposure) which inflates risk for investors, and US regulators have disseminated appropriate warnings as a result.
In Canada, the first single-stock ETFs are yield-focused by seeking to generate distribution yield above any dividends payable on the underlying stock by implementing covered call option strategies (targeted at 50%), but still expose investors to moderate leverage (a maximum of 25% of net asset value).
Rewards – Leverage for All and Higher Yields
The key advantage of the single-stock ETF is that leverage is made accessible to any investor. Single-stock ETFs allow retail investors to have access to margin accounts, where brokers normally need to allow access for such accounts. Brokers have various requirements to obtain margin accounts and not every investor will be able to meet them.
The single-stock ETFs available in Canada seek to generate generous yields by implementing covered call strategies on the individual stocks – this provides investors with a different risk-return profile compared to investing directly in the underlying stocks with no overlay. Single-stock ETFs also provide options to investors seeking tax-loss selling opportunities.
Risks – Divergence and Diversification
Single-stock ETFs are rebalanced on a daily basis, which results in higher fees and long-term returns could look pointedly different to the performance of its namesake stock. The SEC has warned US investors that compounding rebalancing effects can cause single-stock ETFs to diverge from the underlying stock, such effects becoming "especially pronounced in volatile markets" and "especially if these products are held over multiple days or more."2 Massachusetts' top securities regulator has also warned that US retail investors should not consider single-stock ETFs as long-term investments.3
Single-stock ETFs – unless the investor holds several different single-stock ETFs – reduces diversification, the long-cherished advantage of the traditional ETF. In addition, these products exclusively focus on providing daily levered or inverse returns, rather than the traditional long-term returns promised by ETFs. As the SEC have commented, holding a single-stock ETF over multiple days may result in returns diverging "substantially" from the performance of the core stock.4
The Canadian Regulatory Future
We could be entering an era where many of the stocks on the U.S. equity market have a corresponding single-stock ETF available to Canadian retail investors. Indeed, the entry of the single-stock ETF into the "a new ETF-for-everything" market has been described as a "gold rush"5. Without a doubt, the marketability and potential of the product could result in large scale competition but, as always, there will be a number of cautionary tales for retail investors in the years to come.
Public pronouncements by Canadian regulators regarding their approach to single-stock ETFs has been sparse to date6, in stark contrast to the "barrage" of alerts south of the border7. However, when the SEC has gone as far as saying "It would be challenging for an investment professional to recommend such a product to a retail investor while also honoring his or her fiduciary obligations"8, it would be wise to expect future regulatory interest and ultimately oversight over single-stock ETFs from Canadian regulators.
The first opportunity for Canadian regulators to consider single-stock ETFs will be in the context of the Canadian Securities Administrators' ("CSA") review of ETFs announced this month.9 The CSA will consider whether the Good Practices Relating to the Implementation of the IOSCO Principles for Exchange Traded Funds published by the International Organization of Securities Commissions in May 2023 are appropriate for the Canadian market. The CSA will undoubtedly include single-stock ETFs in the scope of its review and therefore regulatory oversight is to be expected in the near future.
Footnotes
1. Purpose Investments Debuts Yield Shares, the World's First Yield-Focused Single-Stock ETFs, Financial Post, December 20, 2022.
2. Statement on Single-Stock ETFs, Commissioner Caroline A. Crenshaw, U.S. Securities and Exchange Commission, July 11, 2022.
3. Galvin Targets Single-Stock ETF Offerings in B/D Sweep | Wealth Management; Single-stock ETFs struggle to get past distributors, Financial Times, October 21, 2022.
4. See Fn 2.
5. Wall Street Set for New ETF Gold Rush as Single-Stock Era Begins, Bloomberg, July 16, 2022.
6. It appears only the Nova Scotia Securities Commission has begun to grapple with the product: What are single-stock ETFs? | Nova Scotia Securities Commission.
7. Leveraged Tesla, Coinbase Funds Lead Next Single-Stock ETF wave, Bloomberg, August 9, 2022.
8. See Fn 2.
9. Canadian securities regulators initiate review of exchange-traded funds, CSA, August 10, 2023.
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