Finding Your Fiduciary Financial Advisor
When you are selecting or retaining a financial advisor, how do you know if you are making the best choice?
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.
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.
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FOOTNOTES
(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.
RISKS
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