Triple Leverage ETFs Should Be Reserved for the Strongest Conviction

Direxion's triple leverage ETFs debuted this week:

• Large Cap (Russell 1K) Bull 3X Shares (BGU)
• Small Cap (Russell 2K) Bull 3X Shares (TNA)
• Energy (Russell 1K Energy) Bull 3X Shares (ERX)
• Financial (Russell 1K Financial Services) Bull 3X Shares (FAS)
• Large Cap Bear 3X Shares (BGZ)
• Small Cap Bear 3X Shares (TZA)
• Energy Bear 3X Shares (ERY)
• Financial Bear 3X Shares (FAZ)

Articles from several sources explain them, including:

• Morningstar -- predictably cautious: "For the average Jane and Joe, these funds have a very limited, if any, place in a portfolio." (So, if you don't use them a lot, you'll know you're just average.)
• ETF Trends -- states the obvious: "They're meant to be used by people who are managing their portfolios very actively, by professional, sophisticated investors." (What? You mean I shouldn't just put my mother's entire retirement account in one of these and wish her well?)
• MarketWatch -- offers a cliche: "Fasten your seatbelts..." (Good one, John! Let's see, volatility, metaphors, rollercoasters and wild rides, seatbelts. Ta-da! I see how you got there, and why you're worth every penny of that Dow Jones salary.)
• Direxion itself -- corporate spittle: "an unprecedented level of leverage in the ETF arena, something that today's dynamic investors are demanding." (If you weren't demanding unprecedented levels of leverage, you just aren't dynamic enough. Spice it up a little, will ya?)

Many people have asked if I'll be switching from the double leverage ProShares in my strategies. I'm not sure yet. It seems that where double leveraged worked before then triple leverage should work better. If we think the market is oversold and due for a bounce, wouldn't a 3X bounce be better than a 2X? Sure it would, but something about there being a limit keeps nagging my thoughts.

Where shall we stop this progression? By the above logic, a 5X bounce would be even better, a 10X really getting somewhere, and a 100X better than betting it all on black while the crowd roars.

The purveyors of leveraged index ETFs get around complicity in the undoing of family finances by saying that the leverage is intended to enable an investor to commit less of their capital to a position because of the leverage. If so, then what's the point?

That reasoning has me taking what would have been a $60k investment in the Russell 2000 and making only a $20k investment in a 3X fund instead. Well, why bother? Maybe so I can put the $40k balance in something else -- maybe a 100X U.S. auto industry ETF -- to diversify. But, if I wanted to diversify the $60k, then I guess I didn't really want to commit it all to the Russell 2000 which, by the way, is pretty well diversified considering there are 2,000 companies in it.

No, we all know that nobody is reducing their allocation to these ETFs proportionally to the leverage they offer. They are used as powerful positions to benefit from a belief in market direction. Bears have done fabulously well with the leveraged bear market ETFs. One day, we'll look back at these times as a superb chance to have committed money to leveraged bull market ETFs.

If pinned down, I would say that use of 3X ETFs should happen only when the market is extremely overstretched one way or the other. They should be reserved for the strongest conviction, not slight probability.

The one-week bounce from extreme oversold conditions that happened from Oct. 28 to election day saw ProShares Ultra Russell 2000 (UWM) gain 45% from $18.03 to $26.20. In the last two days, it dropped 16% to $21.90.

Why anybody would want more action than that is beyond me, but now it's available.

Comments

[NOWHEREMAN:]

The title should apply to anything financial at this time.

Buy only if you have the fortitude to stand associated pain.

2008 Nov 07 08:20 AM

[User 52851:]

If the index it tracks goes down 34%, will it go down 102%? How’s that possible?

2008 Nov 09 04:22 AM

[User 52851:]

If the index it tracks goes down 34%, will it go down 102%? How’s that possible?

2008 Nov 09 04:23 AM

[YITBOSGP:]

BGU could be useful if you find Jason's double the DOW (DtD) strategy too boring for you. I would try Jason's DtD if you haven't already before diving into BGU, to get a feel for the valuation swings of 2x. If you do decide the DtD isn't enough action for you either:

use a portion you would have used for the Double the Dow Strategy to buying BGU
or
Sell a portion of your DtD holding and buy BGU

(I would recommend the former over the latter).

It might also be worth noting that the DtD uses a mutual fund as opposed BGU which is an ETF. A major difference being you can buy/sell into and out of an ETF intraday, whereas the Mutual fund you have to wait until the end of the day for your trade to finalize.

2008 Nov 11 03:04 AM

[Fatty:]

User 52851 -- its not possible for it to go down more than 100%.

So ideally, since its targeting the daily returns, the fund management should have some sort of constant rebalancing strategy in place. For small moves, a periodic rehedging using derivatives should allow them to maintain the approximate leverage ratio. However, as the underlying, targeted asset moves more, the fund will have to rehedge to readjust the leverage ratio.

Basically, I think they would try to provide an "instantaneous" 3x returning portfolio. In typical cases, a day-over-day portfolio value would match this. If they rehedged intraday, it would be from the point where the fund was rehedged that it would be "returning 3x".

So for example, if the benchmark was up 30% and the 3x bear ETF was hedged at every 10% interval, the ETF would be down 30%, three times, or .70*.70*.70 = 44% of the fund would remain at the end of the day, so down 56%. Depending on what their rebalancing strategy was, it could lead to dramatically different end-of-day returns,

2008 Nov 17 11:20 PM

[User 52851:]

I read that these ETF's are rebalanced daily. So my question remains - however unlikely it may be, if the underlying index does go down more than 33.3333% or so, it will go down more than 100%. In fact, that's why I believe we'll never see 10X or 20X ETF's. I'd love to hear more on this.


On Nov 17 11:20 PM Fatty wrote:

> User 52851 -- its not possible for it to go down more than 100%.
>
>
> So ideally, since its targeting the daily returns, the fund management
> should have some sort of constant rebalancing strategy in place.
> For small moves, a periodic rehedging using derivatives should allow
> them to maintain the approximate leverage ratio. However, as the
> underlying, targeted asset moves more, the fund will have to rehedge
> to readjust the leverage ratio.
>
> Basically, I think they would try to provide an "instantaneous&amp...
> 3x returning portfolio. In typical cases, a day-over-day portfolio
> value would match this. If they rehedged intraday, it would be from
> the point where the fund was rehedged that it would be "returning
> 3x".
>
> So for example, if the benchmark was up 30% and the 3x bear ETF was
> hedged at every 10% interval, the ETF would be down 30%, three times,
> or .70*.70*.70 = 44% of the fund would remain at the end of the day,
> so down 56%. Depending on what their rebalancing strategy was, it
> could lead to dramatically different end-of-day returns,

2008 Nov 20 08:17 PM

[laddnyk:]

I believe that these 3x funds are not leveraged. You can get the same bang for 1/3 the money. Can you tell me i am wrong?

Feb 07 12:56 PM

[laddnyk:]

i think the strongest conviction should be used on all trades. if you have a stronger than usual conviction, just put in more money. a cheap way to get the same result as more money is to use a triple ETF. My point is that they are not more risky. They actually are less risky because you can get the same gain (or loss) and risk less money at the same time. That is my definition of conservative. I see all the time that they are leveraged, therefore risky. No one has said they are conservative except me. Am I wrong?

Feb 07 01:20 PM

[American in...:]

You can use these leveraged funds to get three times the long term performance of a benchmark. The key is rebalance your ETF holding.

If your ETF holding has a target return of 3x and its actual performnace is signficantly greater, you sell a part of your holdings. Similarly, if your ETF is generating a return of less than 3X, then you buy more.

There are a number of finance papers that lay out the reasoning and formula.

Volatility is the enemy of leveraged funds. Therefore, the higher volatility, the more often you need to rebalance. A strong upward trend is the friend of leveraged funds.

Aug 30 05:06 AM