Wall Street consistently likes to tap into investor demand, and the latest product that financial innovators have come up with is the single-stock ETF. Rather than holding a diversified portfolio of stocks that share similar characteristics, the purpose of a single-stock ETF is simple and obvious from its name: to offer investors exposure to a single stock.

At first glance, that might seem like a silly proposition. Why buy a single-stock ETF, you might ask, when you could just buy the stock? The answer is that single-stock ETFs offer twists that aren't available from direct stock ownership -- and investors in Tesla (TSLA -12.34%) have found themselves particularly attracted to the features that single-stock ETFs offer them.

Below, you'll learn more about single-stock ETFs, how they work, and why they might be interesting for some investors. By understanding their ins and outs and the potential problems they can have, moreover, you'll be more informed and can make better decisions about whether to use single-stock ETFs in your own investing.

The 2 biggest single-stock ETFs right now

To see single-stock ETFs in action, it's helpful to look at the two that have managed to pull in the most assets under management. These are the Direxion Daily TSLA Bull 1.5X Shares (TSLL -24.89%) and the AXS TSLA Bear Daily ETF (TSLQ 24.99%). Both of these products launched during the summer of 2022, and as their names suggest, they offer opposing ways for investors to get exposure to Tesla stock.

Direxion Daily TSLA Bull 1.5X Shares is an  ETF that uses a type of derivative known as a swap in order to generate daily returns equal to 1.5 times the move in the underlying stock. So if Tesla gains 1% on a given day, then the Direxion Daily ETF expects to rise 1.5%. Similarly, a 1% drop in Tesla should generate a 1.5% drop in the value of the Direxion ETF's holdings.

The AXS TSLA Bear Daily ETF, by contrast, is an inverse ETF. It's designed with derivatives that should produce daily returns that are equal to the opposite of the daily move in Tesla stock. So if Tesla stock gains 1% on a given day, then the AXS TSLA Bear Daily ETF expects to drop 1%. Conversely, if Tesla loses 1%, the AXS ETF should rise 1%.

Don't skip the fine print!

Both of these funds seek to serve a valid investing purpose. Some investors have high levels of conviction in the stocks they buy, and they'd prefer to see outsized gains from them when they do well. Other investors want to bet against certain stocks, but restrictions on short-selling in some types of investment accounts require them to use another means to pursue that strategy.

Just because their purpose is valid, however, doesn't mean that these single-stock ETFs are suitable for every investor. Indeed, each ETF sponsor lists quite clearly some of the risks involved with these funds:

  • Because the ETFs focus on daily performance, they won't necessarily track Tesla's stock price over longer periods of time.
  • Because of their expenses, the ETFs will lose money if Tesla stays flat, and it's possible for an ETF to suffer losses even if Tesla stock moves in the desired direction over longer periods.
  • It's possible that investors could lose their entire investment in a single day if Tesla stock were volatile enough.
  • Because the ETFs track only Tesla, they provide none of the diversification many people associate with ETF investing.

Let the buyer beware

Given that Tesla stock has been sharply lower since these ETFs came out, it's likely that some performance-chasing investors will be tempted by the inverse Tesla ETF. For active traders, such plays are common, and those with short-term goals could justify using ETFs with a daily return focus.

For longer-term investors, though, single-stock ETFs aren't essential for your portfolio. The better course is figuring out how much of your investment assets to dedicate to your favorite stocks. Doing so will save you money in fees and will let you more directly participate in the potential success of the businesses in which you invest.