Investors awaiting ETFs with as few stocks as possible are in luck. Single-stock ETFs have arrived on the scene, providing leveraged or inverse exposure to individual names such as Tesla, NVIDIA, Nike, PayPal, and Pfizer. While some investors may want greater exposure to their favorite companies or to express bearish views on their least favorites, single-stock ETFs may be a case of the wrong thing done for the wrong reason. Single stocks already have a wide range of outcomes, which is amplified when paired with leverage.
While the novelty here is the focus on single stocks, leverage brings the meat of the story. Leverage magnifies returns, which in turn amplifies volatility. A simple example highlights how this could impact an investor’s experience. Suppose you bought $100 of your favorite stock. If it declines by 10% that day and then rebounds by 10% the next, your investment drops to $90 the first day and ends up at $99 the second. Now suppose you had doubled your exposure via leverage. The same 10% decline and rebound in the stock would drop your investment to $80 before bringing it back up to $96. The 2x exposure did not merely double but rather quadrupled your loss. (1)
It is one thing to amplify broad-market-level volatility. It is another thing to amplify single-stock volatility. The average annualized median monthly standard deviation of individual US stocks is around 38% historically (2), which is about double the S&P 500’s historical level of volatility at 19% (3). A one-standard-deviation decline of 38% would translate to a 76% loss at 2x leverage.
Single-stock ETFs eschew a fundamental investment principle, and that is diversification. Research tells us investors cannot reliably predict which stocks will outperform the market. Furthermore, the median stock underperforms the market. And while inverse single-stock ETFs allow investors to express viewpoints or hedge out human-capital exposure by cutting exposure to certain stocks, separately managed accounts (SMAs) provide a more robust platform for employing such preferences. Staking outsize positions on individual stocks could mean neglecting to capture the equity, small cap, value, and high-profitability premiums, missing out on top performers as they emerge, and failing to fully take advantage of the benefits of diversification.
FREE FINANCIAL ASSESSMENT
With all the uncertainty and volatility in today’s economy, the time is now to take a thorough look at your finances. To accurately plan for your financial future, you must first know where you currently stand. For these reasons, our Success Team at Impact Advisors Group is offering a free financial assessment for both individuals and business owners. Request yours today!
This post was written by Wes Crill, PhD (Head of Investment Strategists and Vice President at Dimensional Fund Advisors) with research by Bryan Ting, PhD. This article was also first distributed by Dimensional Fund Advisors.
Named securities may be held in accounts managed by Dimensional. This information should not be considered a recommendation to buy or sell a particular security.
The information in this material is intended for the recipient’s background information and use only. It is provided in good faith and without any warranty or representation as to accuracy or completeness. Information and opinions presented in this material have been obtained or derived from sources believed by Dimensional to be reliable and Dimensional has reasonable grounds to believe that all factual information herein is true as at the date of this material. It does not constitute investment advice, recommendation, or an offer of any services or products for sale and is not intended to provide a sufficient basis on which to make an investment decision. Before acting on any information in this document, you should consider whether it is suitable for your particular circumstances and, if appropriate, seek professional advice. It is the responsibility of any persons wishing to make a purchase to inform themselves of and observe all applicable laws and regulations. Unauthorized reproduction or transmitting of this material is strictly prohibited. Dimensional accepts no responsibility for loss arising from the use of the information contained herein.
This material is not directed at any person in any jurisdiction where the availability of this material is prohibited or would subject Dimensional or its products or services to any registration, licensing or other such legal requirements within the jurisdiction.
“Dimensional” refers to the Dimensional separate but affiliated entities generally, rather than to one particular entity. These entities are Dimensional Fund Advisors LP, Dimensional Fund Advisors Ltd., Dimensional Ireland Limited, DFA Australia Limited, Dimensional Fund Advisors Canada ULC, Dimensional Fund Advisors Pte. Ltd, Dimensional Japan Ltd. and Dimensional Hong Kong Limited. Dimensional Hong Kong Limited is licensed by the Securities and Futures Commission to conduct Type 1 (dealing in securities) regulated activities only and does not provide asset management services.
(1) This can also be expressed algebraically. Suppose r is the return of a single stock between –0.5 and 0.5: (1 – r)(1 + r) = (1 – r2) ≥ (1 – 2r)(1 + 2r) = 1 – 4r2. Note that a 50% decline wipes out a 2x leveraged position.
(2) Source: Dimensional, using data from CRSP and Compustat. Includes all US common stocks without gaps in monthly data for a given rolling year from 1927 to 2020. The statistic reported is an average annualized median standard deviation, where a median standard deviation is calculated for each rolling year formed monthly from the cross-section of stocks available at the start of that month.
(3) Annualized monthly standard deviation of the S&P 500 Index from 1927 to 2020. S&P 500 Index: January 1990–Present, Standard & Poors Index Services Group; January 1930–December 1989, Ibbotson data courtesy of © Stocks, Bonds, Bills and Inflation Yearbook™, Ibbotson Associates, Chicago. S&P data © 2022 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved.
Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a guarantee of future results. There is no guarantee strategies will be successful.
This article explains the student aid index and the 3 different types of SAI’s you might encounter on your financial aid application journey.