Jennifer Choi: Hello, and thank you for joining us today on this Ropes & Gray podcast. I'm Jennifer Choi, a counsel and senior policy adviser in the Washington, D.C. office of Ropes & Gray. Joining me today is my colleague in the asset management practice group, Ed Baer, a counsel in the San Francisco office. In this podcast, which is part of a series of podcasts on ETF issues, we will discuss one of the hottest trends in the ETF space—single-stock ETFs. Single-stock ETFs allow investors to use leverage or make inverse bets on companies, such as Tesla, Nvidia, PayPal and others. There are even some single-stock ETFs designed to provide exposure to so-called "meme stocks." Ed, can you tell me about how these single-stock ETFs work?

Ed Baer: Sure, Jennifer. Single-stock ETFs use leverage to magnify or trade at the inverse of the daily performance of the single-stock they track. For example, there are ETFs that seek to deliver up to 2x the return (or 2x the inverse of the return) of individual stocks, often widely-traded ultra-market-cap stocks.

Jennifer Choi: So, these ETFs track some of the largest and most liquid stocks in the market? Why would an investor need to invest in an ETF (and pay a management fee) when she can just invest directly in the company's stock? What does a single-stock ETF offer that investing in the underlying stock can't?

Ed Baer: Well, the short answer is increased (or, in the case of inverse single-stock ETFs, decreased) exposure to the daily returns of the individual stock (or, in the case of inverse single-stock ETFs, the opportunity to benefit from depreciation in the stock). The investment case for these ETFs, as well as the risks and benefits, are similar to those of other existing leveraged or inverse ETFs in delivering desired returns over a specified period only, which is typically one day. Similar to traditional index-based leveraged and inverse ETFs, these single-stock ETFs use derivatives to seek to achieve their desired returns.

Jennifer Choi: Okay, so unlike leveraged and inverse ETFs that seek to deliver a leveraged or inverse return of the diversified index, these products focus on a single-stock. If held for more than one day, the returns can vary significantly from the exposure because these ETFs reset the leverage daily. In addition, because the returns of these funds are tied to the returns of individual stocks, the volatility of the underlying stocks will be magnified due to the leveraged or inverse nature of the ETFs.

Ed Baer: That's right. These are not buy-and-hold vehicles. The issuers of these products have attempted to make it clear that these are sophisticated investment tools designed to provide active traders, who are focused on making very short-term trading decisions and who have a strong directional view on a certain stock, the opportunity to make tactical trading decisions based on company news such as earnings announcements or regulatory developments.

Jennifer Choi: Speaking of regulatory developments, the SEC and FINRA have their eyes on these products. Shortly before the first single-stock ETFs came to market, SEC Commissioner Crenshaw warned "Because of the features of these products and their associated risks, it would likely be challenging for an investment professional to recommend such a product to a retail investor while also honoring his or her fiduciary obligations or obligations under the Regulation Best Interest. However, retail investors can and do access leveraged and inverse exchange-traded products through self-directed trading." At the same time, the Director of the Office of Investor Education and Advocacy cautioned that "Holding a levered and/or inverse single-stock ETF is not the same as holding the underlying stock, a traditional ETF, or even a non-single-stock levered and/or inverse ETF. It is riskier for several reasons." She then went on to talk about the short-term nature of the exposure and the lack of diversification in underlying exposures.

And at a conference recently, senior SEC staffers noted that Chair Gensler has asked the staff to focus on complex products such as leveraged and inverse ETFs, including single-stock ETFs, so there may be additional regulation forthcoming. We understand that the Division of Investment Management is working with the Division of Trading & Markets and the Division of Economic and Risk Analysis to understand the market impact of single-stock ETFs.

Another concern of the SEC is that issuers looking to launch single-stock ETFs on foreign stocks that don't have to meet the same financial reporting standards as a U.S.-listed company. The SEC is concerned about American investors gaining access to foreign companies that wouldn't be able to access them directly.

Ed Baer: Exactly. While it's unclear whether the SEC can do anything to stop the launch of single-stock ETFs on non-U.S. stocks, they're definitely concerned that U.S. investors could be harmed. Interestingly, one of the firms that filed a registration statement for a series of single-stock ETFs on non-U.S. stocks in early September withdrew the registration statement for those ETFs about two weeks later. It is unclear whether the withdrawal was voluntary or whether the SEC asked the sponsor to withdraw the registration statement. I expect there will be more to come on these products in the near future.

In addition to the SEC focus, FINRA's recent Complex Products proposal focused on an extremely broad list of "complex products," including leveraged and inverse ETFs. This may result in additional sales practice restrictions or new disclosure obligations. Unsurprisingly, the ETF industry reacted very negatively to the FINRA proposal, especially the portion of the proposal that suggested that self-directed investors might not be permitted to invest in "complex products" like leveraged and inverse ETFs.

Jennifer Choi: What I find curious is the timing of the launch of these products in the U.S. Products like these have existed in Europe for years, but they've only recently found their way to the U.S. There are about two dozen of these single-stock ETFs in the market already, and there are dozens more in registration, including single-stock ETFs that track non-U.S. securities. And all of these have launched since July. Why now?

Ed Baer: For starters, the adoption of the ETF Rule, as well as the Derivatives Rule, really opened things up. For years, the SEC refused to permit new exemptive orders allowing leveraged and inverse ETFs, so product innovation in this area was stifled. The ETF Rule, when combined with the Derivatives Rule, permits additional issuers to launch new leveraged and inverse ETFs, including single-stock ETFs, so there are a number of issuers that have entered the leveraged and inverse ETF market. At the same time, I wouldn't be surprised if these products are seeking to take advantage of some of the trends related to meme stocks and the "gamification" of trading, two areas the SEC is definitely focused on. One thing I've noticed about single-stock ETFs is that the amount of targeted leveraged or inverse return tops out at 2x leverage or -2x leverage. For years, there have been 3x leveraged or inverse ETFs. Why aren't there 3x leveraged or inverse single-stock ETFs?

Jennifer Choi: What it boils down to is how much leverage can you achieve consistent with the 40 Act's Derivatives Rule? Under the new Derivatives Rule, funds have to comply with one of two different "value at risk" or "VaR" tests—the relative VaR test or the absolute VaR test. A fund will satisfy the relative VaR test if its portfolio VaR doesn't exceed 200% of the VaR of its "designated reference portfolio" or "DRP." A fund that doesn't have a DRP will satisfy the absolute VaR test if its portfolio VaR doesn't exceed 20% of the value of the fund's net assets. As a result, 2x leverage or -2x inverse leverage is the maximum leveraged or inverse exposure attainable by open-end funds under the Derivatives Rule. However, at the time the Derivatives Rule was adopted, the SEC grandfathered in existing index-based 3x and -3x leveraged and inverse ETFs.

Ed Baer: That makes sense, but not all of these single-stock ETFs seek up to 2x leveraged or 2x inverse leveraged exposure. Instead, issuers of single-stock ETFs appear to have concluded, based on the volatility of the underlying stocks, that less than the maximum permitted leveraged or inverse exposure is desirable, so there are products out there that establish lower leveraged and inverse targets (such as 1.5x leveraged or 1.5x inverse leverage). I think the lesson for investors is that if you are thinking about purchasing a single-stock ETF, understand what the precise exposure of the ETF will be, and do not view the single-stock ETF as a buy-and-hold investment.

Jennifer Choi: That's right. These things can be risky and even more volatile than the underlying stocks, so invest carefully.

Well, that brings us to the end of the podcast. Ed and I want to thank you all for joining us on this discussion of single-stock ETFs. For more information on the topics that we've discussed or other topics of interest to asset managers and ETF sponsors, please visit our website at www.ropesgray.com, where we have links to some additional material regarding these topics. To help you better understand the current ETF landscape, we'll be issuing several additional podcasts designed to provide a greater depth of analysis on important and timely ETF issues. If you have any questions regarding the topics we have addressed or anything else, please don't hesitate to get in touch with one of us or whomever you have a working relationship with at Ropes & Gray. You can also subscribe and listen to the series of podcasts wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thank you again for listening.

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