ETF Folly: Triple-Leverage Financials, and Other Triple-Leverage ETFs

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The Direxion Daily Financial Bull 3X Shares (NYSEMKT: FAS) and the inverse Direxion Daily Financial Bear 3X Shares (NYSEMKT: FAZ) are leading our Daily ETF Folly feature ahead of the coming bank stress tests from the Federal Reserve. Our aim is not to beat up on this exchange traded fund (ETF) family, but we want to reiterate our first rule of investing: You must fully understand what you are investing in!

Many investors have finally figured out (some the hard way) that there are many more risks to these triple-leverage ETFs than just the daily price change of major banks and financials. The average daily volume has adjusted along with the splits and reverse splits that these ETFs have endured through time. What else makes the folly is that these two and 14 other leveraged ETFs are in the process of undergoing stock splits or the dreaded reverse stock splits.

With the bank stress tests due momentarily, you might think that there would be more interest in these ETFs. After all, they offer triple leverage and do not require you to leverage up on margin in most online trading accounts. In recent years, efforts have been made to limit brokers from suggesting these ETFs to retail clients, and some firms have a policy against these outside of an outright customer demand to invest in them.

So, the real folly in these is not just in the two triple-leverage financial sector ETFs. Direxion announced on March 1 that, starting after the close on April 1, 2013, a whopping 16 of its leveraged ETFs will have stocks splits or reverse stock splits.

It was highly unusual in the past when you saw these stock splits start to take place in the world of ETFs. After so many sectors were wiped out, there even began to be reverse stock splits in some of the nonleveraged ETFs out there as well from other fund management families. Now take some of the risks outlined by Direxion in the Direxion Daily Financial Bull 3X Shares (NYSEMKT: FAS) prospectus supplement, which is dated March 1, 2013. Three risks stand out that you do not see in nonleveraged ETFs:

  • The pursuit of daily leveraged investment goals means that the return of the Fund for a period longer than a full trading day may bear no resemblance to 300% of the return of its index for such longer period because the aggregate return of the Fund is the product of the series of daily leveraged returns for each trading day.
  • The path of the benchmark during the longer period may be at least as important to the Fund’s return for the longer period as the cumulative return of the benchmark for the relevant longer period, especially in periods of market volatility.
  • Further, the return for investors that invest for periods less than a full trading day or for a period different than a trading day will not be the product of the return of the Fund’s stated goal and the performance of the target index for the full trading day.

Another issue to consider is that these two triple-leverage ETFs have total fund annual operating expenses of 1.00%. That implies that not only do they have price erosion, as the ETFs do not truly capture overnight or off-market price changes, but investors also will see 10% price erosion if they theoretically held for 10 years. The fund gets more specific and shows what the implied costs would be through time if you assume 5% share price gain each year on a $10,000 initial investment and sell at the end of each theoretical period along with the same static management fee: one year: $102; three years: $318; five years: $552; and 10 years: $1,225.

Before you get too upset, we are not calling the Direxion ETFs anything wrong. The reality is that using leverage, futures and daily price moves makes it virtually impossible for there to not be any tracking errors and price erosion. The higher fee is also due to the type of fund this is. The managers cannot just simply buy and sell a basket of stocks each minute that they get buy and sell orders as you might see elsewhere.

It is also impressive that the Direxion prospectus supplement specifically screens out retail and individual investors who are not as sophisticated. It states:

The Fund is designed to be utilized only by knowledgeable investors who understand the potential consequences of seeking daily leveraged investment results, understand the risks associated with the use of leverage and are willing to monitor their portfolios frequently. The Fund seeks daily leveraged investment results relative to the Index and is different and riskier than similarly benchmarked exchangetraded funds that do not use leverage. Therefore, the Fund is not intended to be used by, and is not appropriate for, investors who do not intend to actively monitor and manage their portfolios.

Direxion also shows why the management of these funds is much more challenging than a nonleveraged ETF. It shows what it invests in as the following under “normal circumstances” for investors:

[A]t least 80% of its assets in the securities that comprise the Russell 1000 Financial Services Index and/or financial instruments that provide leveraged and unleveraged exposure to the Index. These financial instruments include: futures contracts; options on securities, indices and futures contracts; equity caps, floors and collars; swap agreements; forward contracts; short positions; reverse repurchase agreements; exchange-traded funds; and other financial instruments. It may also may hold short-term debt instruments that have terms to maturity of less than 397 days and exhibit high quality credit profiles, including U.S. government securities and repurchase agreements.

Again, the folly here is not pointing out that the triple-leverage ETFs are a sham or that they are bad ETFs. Managing these must be incredibly difficult, and there is really no way that the managers can avoid or escape the price erosion and tracking errors that will occur through time. The fund group is also extremely specific to point out these are not suitable for many investors.

That being said, we again want to state, “You must fully understand what you are investing in!” Here are the other ETFs that are undergoing splits and reverse splits.

Splits with ratios as follows:

  • Direxion Daily Financial Bull 3X Shares (NYSEMKT: FAS) 3:1
  • Direxion Daily Retail Bull 3X Shares (NYSEMKT: RETL) 3:1
  • Direxion Daily Emerging Markets Bull 3X Shares (NYSEMKT: EDC) 3:1
  • Direxion Daily S&P 500 Bull 3X Shares (NYSEMKT: SPXL) 3:1
  • Direxion Daily Real Estate Bull 3X Shares (NYSEMKT: DRN) 2:1
  • Direxion Daily Latin America Bull 3X Shares (NYSEMKT: LBJ) 2:1
  • Direxion Daily 7-10 Year Treasury Bull 3X Shares (NYSEMKT: TYD) 2:1
  • Direxion Daily Small Cap Bull 3X Shares (NYSEMKT: TNA) 2:1

Reverse splits with ratios as follows: