How Leveraged Single-Stock ETFs Keep Us Guessing

Leveraged Single-Stock ETF 101

Leveraged Single Stock ETFs (LSSEs) hit the market in 2022. If you aren’t familiar with them, LSSEs are ETFs designed to amplify the performance of a single stock. These funds achieve their goal of obtaining amplified returns by deploying a series of derivates. For example, a fund’s objective may be to get a two-ex multiple of the daily returns in Apple Inc. (ticker: AAPL). In this case, the fund might comprise call options, total return swaps with counterparties, or futures contracts, all of which seek to mimic the behavior of being two-ex exposed to the underlying stock. Or, less commonly, you may have an inversed LSSE, where the fund seeks a negative multiple of the daily returns in a given stock. To learn more about LSSEs, you can check out the SEC’s Statement of Single-Stock ETFs (here). Now, these funds seem kind of cool at first glance, right? They allow you to amplify your daily returns on a trending stock like Apple Inc. or NVIDIA. However, there’s sort of a catch. Well, it's not really a “catch,” but something to watch out for. LSSEs rebalance on a daily basis to maintain their leverage ratio, making their performance over a long horizon deviate significantly from the expected multiple of the stock’s return. This is called leverage decay, i.e., the gradual erosion seen in LSSEs returns over time. Now that you better understand what LSSEs are, I can proceed forward with my rant.

Why I’m Writing This (and Why You Should Care)

Before I begin, I’d like to mention that I never intended to sit here and write about why I dislike how LSSE issuers publish their daily holdings data. In fact, I can’t name a single other twenty-one-year-old who would, especially on their break home from college. However, I encountered this issue while trying to price out the intraday net asset value (NAV) for LSSEs. I was curious about measuring the pricing deviations between LSSEs and their intraday NAVs, specifically because of the daily liquidity ranges for certain LSSEs. To be more exact, there are a handful of LSSEs with a daily volume range between two million and ten million USD. Now, this is interesting to me for two main reasons.

1. Due to this daily traded volume range being so low, there is most likely going to be some type of “lag/delay” between the time in which a massive price change in the underlying stock (e.g., Apple Inc.) occurs and the time in which the corresponding LSSE experiences the effect of that price change. Additionally, to go one step further, the LSSE might not even be impacted by subtle price changes in the underlying stock, resulting in minor spread fluctuations.
2. If an LSSE trades in this volume window, there is a lower likelihood of direct competition from larger firms with faster infrastructure. For example, let’s say that one can successfully trade five percent of the average daily volume before experiencing extreme market impact. In this case, the trader would be trading an average of one hundred thousand to five hundred thousand USD daily. Let's say this trader has found a serious edge and is netting an average of fifty percent annualized returns (post fees). This means the trader walks away with anywhere from fifty thousand to two hundred fifty thousand USD annually. Now, let's say the trader has comprised a basket of ten LSSEs, all of which fall within this liquidity range and return the same fifty percent annualized return (post fees). The trader is now walking home with anywhere between five hundred thousand and two million five hundred thousand USD annually. This number shrinks tremendously within a large or even a medium-sized firm due to infrastructure costs, performance payouts, etc.

So, in my opinion, this trade makes more sense for a trader (or team of traders) with low infrastructure costs and low assets under management (AUM), as opposed to a larger, more established firm.

Active ETFs Share Their Secrets—Why Don’t LSSEs?

Opposed to LSSEs, pricing out the intraday NAV for actively managed ETFs is a relatively simple and valuable task. As of August 2012, actively managed ETFs were required to publish their holdings daily. The SEC states explicitly in their Investor Bulletin for ETFs that “because there is no index that can serve as a point of reference for an actively managed fund’s holdings, publishing the specific holdings allows the arbitrage mechanism to function. As explained above in the section on Arbitrage, this arbitrage mechanism generally keeps the market price of the ETF shares close to their NAV” (U.S. Securities and Exchange Commission). Intuitively, this makes sense. It would be a weird feeling if ETFs were “walking” around at a persistent discount or premium to their NAV, so I guess the SEC’s thought process went a little something like this: traders have no way of finding daily holdings for actively managed ETFs. They can see the quarterly holdings in N-PORTP filings, but a lot can happen within a given quarter, so we should probably make the issuers of actively managed ETFs post their holdings on a daily basis. Now, this makes sense and makes the markets more efficient (don’t quote me on this, as the head of research at Clarium would have most definitely fired me for saying that if I were one of their interns). The argument by the SEC is quite simple. One can’t actively price out an actively managed ETF because the goal of the ETF may be something that isn’t very concrete. For example, take Simplify Healthcare Care ETF. Their investment objective is as follows: “The Simplify Health Care ETF (PINK) seeks long term capital appreciation by providing investors with multi-cap exposure to groundbreaking and innovative companies in biotech, medtech, gene therapy, and other fast growing health care related sectors.” This is quite hard to price out without having the holdings directly because groundbreaking and innovative companies are subjective. Unlike an ETF, which seeks to replicate the S&P 500, an actively managed ETF is much harder to determine the intraday NAV for.

Why LSSEs Need to Come Clean

My argument is as follows: LSSEs are specifically designed to amplify the daily performance of a single stock. While not as subjective as the holdings in an actively managed ETF, the amplified performance of a single stock isn’t as intuitive as, say, following an index like the S&P500. This is because you can’t specifically trade a single stock's amplified daily performance. You can seek to obtain a single stock’s amplified daily performance, but you can do this in many different ways. You can do this through call options, total return swaps, etc. Most importantly, each way you seek to obtain amplified daily returns for a given stock has its own set of risks and rewards, thus making each way entirely different from one another. I see why it would be redundant for an index-based ETF issuer to post their holdings daily; anyone can find those holdings by analyzing the index itself. However, I fail to see how I can analyze where an LSSE is achieving its desired amplified returns daily. One might argue that it’s also redundant for an LSSE issuer to post holdings daily because the NAV is simply just the amplified daily returns of its underlying stock. However, if this were the case, how would one explain the leverage decay that we see in LSSEs?

Almost Transparent, But Not Quite Enough

Most LSSE issuers post some form of daily holdings. Take Granite Shares’ 2x Long AAPL Daily ETF (ticker: AAPB), for example. You can download the “holdings” from the previous day on the issuer's website. However, these “holdings” look like this:

It is difficult to tell what the LSSE holds to achieve a 200.50% exposure to Apple Inc. stock. Now, we can access the SEC EDGAR Database and analyze the difference between two N-PORTP filings for this fund (CIK: 0001689873, Series: S000076355).

SEC Filings

NPORT-P Filing for 2024-03-31 View Filing

• Total Exposure to Apple Inc.: 200.5%
• Net Assets: $19,658,436.93 USD
• Holdings: AAPL stock, AAPL total return swaps

NPORT-P Filing for 2023-12-31 View Filing

• Total Exposure to Apple Inc.: 175%
• Net Assets: $3,671,847.74 USD
• Holdings: AAPL total return swaps

As we can see, these NPORT-P filings found on the SEC EDGAR Database provide in detail the holdings for this given LSSE over back-to-back quarters. As seen in the filings, the primary source for the leveraged returns comes from a mixture of AAPL stock holdings and AAPL total return swaps. Given that we are provided the price of AAPL at the start of the swap, the notional number of shares (notional value divided by AAPL price at the start of the swap), the accumulated dividends on AAPL since the start of the swap, and the floating interest payments accrued since the last reset, we can calculate a very good proxy for NAV of the swap as follows:

However, due to the extreme difference between the fund’s holdings each quarter, using NPORT-P holdings data would be a stale data source. Additionally, LSSEs update their holdings as frequently as daily, aligning with their constant rebalancing to maintain consistent leverage. So, as detailed as NPORT-P filings are, they will not serve as a proper source for calculating daily NAV and allowing arbitrage mechanisms to function in LSSEs.

Conclusion

In short, I don’t see why LSSEs aren’t required to publish their holdings daily, but actively managed ETFs are. Calculating daily NAV and NAV throughout longer time horizons is practically impossible without the LSSE’s issuer providing fully disclosed holdings daily. But, to really sum up this blog post, I’m just upset that I spent a whole day researching how I could calculate NAV for LSSEs just to find out that I can’t.