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Single-stock exchange-traded funds (ETFs) have been lauded for their innovation and criticized for the high risks they entail when first launched in the U.S. last summer. But a new suite of Toronto-listed ETFs puts a new, less risky spin on the strategy, garnering increasing interest from Canadian advisors.
“The U.S. single-stock ETFs have daily leverage applied to them … that creates almost radioactive risk for investors,” says Daniel Straus, director of ETFs and financial products research at National Bank Financial Inc. in Toronto.
Providing 100 to 175 per cent long or short exposure to the daily movement of singular, large-cap U.S. companies, such as Tesla Inc. TSLA-Q, U.S. single-stock ETFs quickly raised concerns from regulators as many investors did not understand the steep downside risks of this type of leverage, he adds.
However, late last year, Toronto-based ETF provider Purpose Investments Inc. launched a suite of single-stock ETFs for a handful of large-cap U.S. companies, including Tesla, involving a less risky approach.
“These ones take advantage of recent regulatory changes allowing for modest use of leverage inside an ETF,” Mr. Straus notes, referring to amendments to National Instrument 81-102 that came into effect in 2019.
Purpose Investments launched five ETFs in late December – Tesla Yield Shares Purpose ETF YTSL-NE, Amazon Yield Shares Purpose ETF YAMZ-NE, Alphabet Yield Shares Purpose ETF YGOG-NE, Apple Yield Shares Purpose ETF APLY-NE and Berkshire Hathaway Yield Shares Purpose ETF BRKY-NE.
Each NEO Exchange-listed ETF offers exposure to the underlying stock while applying 25 per cent leverage to the position, a covered-call overlay on 50 per cent of assets, and a currency hedge to Canadian dollars.
Why the Canadian products are different
Altogether, these characteristics make the funds unique to North American markets, says Nicholas Mersch, portfolio manager with Purpose Investments.
Designed to generate high yields from call options premiums, providing monthly income distributions, the ETFs are suitable for holding over longer periods, he adds.
That’s in contrast to the U.S.-listed single-stock ETF offerings such as Direxion Daily AAPL Bull 1.5X Shares AAPU-Q that can result in significant decay in net asset value when held for more than a few days.
“These synthetic, pretty exotic equity instruments are not really safe for retail investors,” Mr. Mersch explains. “So, we wanted to offer a strategy that was easy to understand that generates yield while still offering exposure to the underlying company.”
At the same time, the “modest leverage” makes up for a portion of lost upside if the underlying stock’s price rises significantly, resulting in 50 per cent of the stock “being called away,” he adds.
“Already, the strategy proved it was able to capture most of the upside for Tesla [in January],” Mr. Mersch says, referring to Tesla Yield Shares Purpose ETF’s about 56 per cent increase in the month compared with the actual stock’s price gain of 60 per cent.
Besides offering a covered-call overlay, a popular strategy already amid volatile markets, Purpose ETFs give Canadian investors access to U.S.-listed companies via a Canadian exchange, offering the convenience of trading in Canadian dollars while potentially avoiding U.S. tax complications when held in non-registered accounts.
In this respect, these single-stock ETFs may differ from Canadian depository receipts (CDRs) that CIBC Capital Markets launched in 2021, providing direct exposure to several popular U.S. names including Walt Disney Canadian Depositary Receipts DIS-NE.
CDRs, Mr. Mersch explains, can require U.S. tax filing when invested assets exceed certain thresholds, whereas ETFs do not.
Given all their potentially advantageous features, single-stock ETFs are garnering advisors’ interest, but the challenge is “figuring out how to fit it in the portfolio,” Mr. Mersch says.
One strategy, he says, is adding the ETFs to already existing holdings of the same U.S.-listed stocks – taking up between 10 and 50 per cent of the overall position – to provide a more defensive stance in volatile markets.
“Think of it as collecting rent while housing your favourite U.S. securities,” he says about the distribution yields ranging from about 15 per cent for Tesla Yield Shares Purpose ETF and 6 per cent for Berkshire Hathaway Yield Shares Purpose ETF.
Risk-adjusted exposure with a covered call
Darren Coleman, senior portfolio manager, private client group with Coleman Wealth at Raymond James Ltd. in Toronto, is among the advisors interested in these ETFs.
“What’s interesting is that these create income where none exists, like Berkshire Hathaway stock,” he says.
Equally significant is that he can now offer clients, who want to own Tesla, risk-adjusted exposure with a covered-call overlay.
Whether the electric vehicle automaker’s stock recovers to its past peak or not, “the stock will likely remain volatile because investors trade it like crazy, and so, I can turn that into an income opportunity for clients,” he says.
In general, Canadian single-stock ETFs provide “another tool for the toolbox,” particularly for aging clients who need more income and may not be able to handle the volatility of unfiltered exposure to Amazon.com Inc. AMZN-Q, for example, along with potential long-term growth, he adds.
What to watch out for
Still, the ETFs have risks – although not as severe as their U.S. counterparts.
“Likely the most adverse scenario is you buy the ETF, the underlying stock price tumbles, and you’re down 25 per cent more than otherwise because of leverage,” Mr. Straus explains.
Further compounding the problem, the covered calls written at that juncture may limit the ability “to recoup initial losses” if the strike prices are close to the units’ initial purchase price, he adds.
The risks speak to how advisors must be certain clients understand leverage, options strategies and associated risks, Mr. Mersch says. “There can be a big education process.”
Still, the newly launched ETFs have been successful enough that Purpose Investments aims to launch five more this year, including ones for Unitedhealth Group Inc. UNH-N and Exxon-Mobil Corp. XOM-N, “allowing for more diversification,” he adds.
In theory, you could create a single-stock ETF for any security with a “deep options market,” Mr. Mersch says.
More choice likely would be welcome among advisors seeking more ways to drive returns for clients, Mr. Coleman says.
“Diversification is a paradox in which you lower risk by taking as many unique and different risks as possible,” he says. “These ETFs add another diversification dimension.”
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