ETFs that give that give retail investors magnified exposure to individual stocks are booming. That could be an ominous sign for the market, and for the funds themselves as glitches emerge.
Leveraged single stock ETFs hit a record of $17 billion of trading volume on Nov. 21, according Strategas ETF strategist Todd Sohn. Several issuers have launched these funds in recent years, typically tracking stocks with high volatility like Nvidia, Tesla and MicroStrategy.
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"The entire leveraged cohort is just 0.4% of U.S. ETF AUM, but with trading volume as % of total constantly flirting with the 8-9% range recently – that's up from 4% at the start of the year and we find the growth rate curious with equities trading at an all-time high," Sohn said in a note to clients last week.
The volume would seem more likely to spike during downturns in the market, when general volatility rises, not well into a bull market, Sohn said. Their recent popularity could be a warning sign about euphoria among some investors.
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"Pair this off with the continued surge of inflows to equity ETFs and it creates a developing case of hot sentiment. Keep in mind – year 3 of a bull market is often a trickier backdrop than the initial years off major market lows," Sohn said.
Similarly, Morningstar senior analyst Daniel Sotiroff told CNBC the rise of these types of leveraged funds funds is indicative of a "gambling mentality" in the market and that investors would be better off avoiding them altogether.
MicroStrategy funds
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For now, the broader Wall Street rally is still intact, but there are new signs of strain for some of the single stock ETFs.
One of the big concerns around leveraged funds in general is that they are only designed to meet their stated return on a daily basis. Because of a characteristic often called "volatility drift," investors can expect leveraged long funds in particular to underperform the goal on the label over longer time horizons.
But the soaring popularity of leveraged funds for MicroStrategy in particular has surfaced a different problem: the funds are struggling to track the volatile crypto-linked stock on even a daily basis.
Return data from FactSet shows that, in the five trading days leading up to Thanksgiving, two major leveraged long MicroStrategy funds had multiple trading sessions where their return differed from the stated goal by more than 2 percentage points.
The single stock funds typically buy swap agreements from banks to lock in the leveraged exposure. However, the T-Rex 2X Long MSTR Daily Target ETF (MSTU) and the Defiance Daily Target 2X Long MSTR ETF (MSTX) have both turned to options to generate leverage in recent days because there wasn't enough supply in the swaps market, the firms behind the funds confirmed to CNBC, which could make it more difficult to achieve the goals of the funds.
The two funds have more than $4 billion in combined assets, according to their websites. The heavy demand for the funds, combined with the high volatility of MicroStrategy itself, appears to be scaring off financial firms from helping facilitate these leveraged bets on the stock with swaps.
"Every strategy has its limits at some point. Sometimes it's like a structural thing where the market just cannot handle any more, like you're kind of seeing now. Sometimes its more based on the particulars of the strategy," Sotiroff said.
Despite the recent issues, the single stock ETF boom is still growing. On Tuesday, Defiance launched the Daily Target 2X Long NVO ETF (NVOX), giving leveraged exposure to the stock of obesity drug maker Novo Nordisk.