Thursday, July 14, 2022

Arrival of single-stock ETFs draws cautionary advice from SEC officials

By John Filar Atwood

Rule changes at the SEC and at the major exchanges have paved the way for companies to offer single-stock ETFs without Commission review, and two SEC officials are sounding the alarm to the average investor about the risks of the new products. Lori Schock, Director of the Office of Investor Education and Advocacy, and Commissioner Caroline Crenshaw warned that holding a levered and/or inverse single-stock ETF is much riskier than holding the underlying stock, a traditional ETF, or even a non-single stock levered and/or inverse ETF.

Single-stock ETFs provide leveraged, inverse or complex exposure to a single security rather than a portfolio of multiple securities as with typical ETFs. Similar to other complex exchange-traded products, levered and/or inverse single-stock ETFs provide returns over extremely short time periods, sometimes as short as one day.

No more Commission review. The adoption by the SEC of Investment Company Act Rule 6c-11 followed by listing standards changes at several exchanges have opened the door for the new products. Prior to the passage of Rule 6c-11, Crenshaw noted, ETFs had to meet certain listing criteria established by rules at the relevant exchanges, and single-stock ETFs would not have satisfied those criteria. They would have needed Commission approval before coming to market.

Now products that are deemed ETFs under Rule 6c-11 automatically qualify for listing under exchanges’ listing rules without an opportunity for public notice and comment, Crenshaw said. This is true even if the leveraged and inverse products qualifying under the rule present many of the same risks to investors and the markets that previously would have required Commission review, she added.

Crenshaw lamented that nowhere in Rule 6c-11 is there a discussion of single-stock ETFs, or an indication that the rule contemplated the products. Still, single-stock ETFs are coming to market under the auspices of that rule, she said.

Inherent risks. Schock pointed out that single-stock ETFs are riskier than traditional ETFs or a non-single stock ETF for several reasons. They try to provide returns over short time periods, so risks may emerge for investors who hold the products longer, she noted. Investors should be aware that if they were to hold the funds for longer than a day, the performance may differ significantly from the levered and/or inverse performance of the underlying stock during the same period of time, she advised.

In addition, Schock noted that levered and/or inverse single-stock ETFs track the price of a single stock rather than an index and eliminate the benefits of diversification. In her view, because levered single-stock ETFs particularly amplify the effect of price movements of the underlying individual stocks, investors holding these funds will experience even greater volatility and risk than investors who hold the underlying stock itself.

Crenshaw echoed the concern about the risks inherent in single-stock ETFs, but also presented her broader view that a comprehensive review of complex exchange-traded products is long overdue. She noted that she and former Commissioner Allison Herren Lee called for improvements to the regulatory framework for complex exchange-traded products last year, and she expressed disappointment that no steps have been taken by the Commission.

Call for rulemaking. She said she is particularly disappointed that with respect to single-stock ETFs the agency has thus far failed to make use of its rulemaking powers to address the question of whether the products are in the public interest and consistent with the protection of investors. She called for the Commission to consider rulemaking on single-stock ETFs to address the investor protection concerns and market risks that they and other exchange-traded products can present.