Direxion's Leveraged ETFs Triple the Risk

When ETF issuer Direxion launched its Financial Bull 3X Shares (FAS) and Financial Bear 3X Shares (FAZ) in November of 2008, market volatility was skyrocketing, providing an attentive audience of nervous investors anxious to pick sides in an uncertain environment. Eight months later, bullish FAS has dropped more than 60% while bearish FAZ has plummeted 96% as the funds’ methodology has mercilessly taken its toll on both share prices. The Direxion pair has intensified an existing debate on the role of leveraged funds, which have experienced booming popularity as investors use ETFs to make previously inaccessible bets. The trend toward leverage has not gone unnoticed, however, and as leveraged funds are pushed into the spotlight, it is more important than ever for investors to understand what they’re getting.

Investors may be perplexed as to how both a bull strategy (FAS) and a bear strategy (FAZ) can be leveled simultaneously. The reason, while potentially controversial, is not a mystery to investors with the initiative to look: the disclaimer is front and center on Direxion’s home webpage. “Direxion Shares ETFs seek daily investment goals and should be used strictly as short term trading vehicles,” the website warns, highlighting the daily reset strategy of the fund. As the value of the fund vacillates, the daily impact is compounded, sinking both funds over time.

The Financial Industry Regulatory Authority (FINRA) issued a recent ruling to further protect investors who should avoid leveraged funds. The ruling notes that:

“While the customer-specific suitability analysis depends on the investor’s particular circumstances, inverse and leveraged ETFs typically are not suitable for retail investors who plan to hold them for more than one trading session, particularly in volatile markets.”

FINRA’s regulatory measure urges advisor firms to have adequate supervisory procedures in place to make sure that financial advisors are meeting their fiduciary responsibilities regarding the suitability, education and marketing of leveraged ETFs. FINRA also highlighted a marketing requirement that leveraged ETF material must include the disclosure about the daily return period and daily rebalancing. Issuers also have to disclose how their strategies will play out over the long term, helping investors to understand the erosion of funds like FAS and FAZ over time.

A recent announcement from U.S. Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler could also have an impact on leveraged commodity funds such as ProShares’ line of leveraged commodity ETFs. ProShares launched 12 leveraged commodity ETFs in late 2008, including ProShares Ultra DJ-AIG Commodity (UCD), ProShares Ultra Short DJ-AIG Commodity (CMD) and ProShares Ultra DJ-AIG Crude Oil (UCO). Gensler announced June 7 that the agency will hold hearings this summer to consider imposing position limits for “all commodities of finite supply.” Regulations would likely impact exchange-traded fund issuers who currently have a loophole through commodity limits due to special hedge exemptions.

Usually exchanges impose limits on commodity trading to discourage excess speculation, but because of their structure, ETFs have been given a pass thus far. Any regulation that sets limits on commodities in the exchange-traded fund structure would impact the numerous ETFs based on commodity futures, and the effect would be exaggerated for leveraged commodity ETFs. Fund issuers may be forced to restructure the way that their ETFs operate and may find other ways to shift the bright spotlight of regulatory concern off of their funds in the meantime.

The ETF industry has begun to react to growing concerns about the fleecing of shareholders. Direxion, issuer of the wildly popular FAS and FAZ ETFs, recently announced a reverse split for the two products, slated for July 8. FAZ, which closed at $7.89 on July 7, will experience a 1-for-5 reverse split, while cheaper FAZ, which closed at $5.39 on July 7, will reverse split 1-for-10. The move will result in imperfect odd lots, fractional shares ineligible for trading that can be redeemed on a onetime basis for NAV. The resulting payout is taxable, a fact that may vex small shareholders.

Direxion’s reverse split may help to refocus FAS and FAZ, and the leveraged ETF industry as a whole, as investors process this important piece of ETF news. As of press time (July 7) FAZ and FAS are currently two of the highest-volume securities traded on the U.S. exchanges. A heightened share price may dampen the roaring trading volume, which has drawn an inordinate amount of attention to these potentially dangerous funds. In a note on its website, Direxion alerts investors that higher share prices will help to defray transaction costs as spreads become relatively smaller to the overall share price. As it says on the label, FAS and FAZ were intended for sophisticated short-term traders—Direxion’s split and recent announcements from FINRA and the CFTC should help to drive the message home to the average investor.

One of the taglines on Direxion’s front page notes that the funds are “ETFs to the Power of X.” As long as investor interest continues to grow, leveraged ETFs could continue to multiply their intensity, in the manner of popular razor blades, to a seemingly ridiculous extent. Direxion is not the first leveraged ETF issuer; however, the world of leveraged ETFs is still young. Regulation will likely come to this arena in the upcoming months, and investors should check their bets before the cards are called. Leveraged ETFs can be used responsibly, but they must be understood thoroughly before the trade is made.

Comments

[johnny inca:]

I will be very sad if they pull the plug on FAS and FAZ because I have been running about 10% gains monthly by being short both. The reverse split was a huge bonus as it lowered the margin requirements for the position immensly, so thanks Direxion for that.

Jul 10 09:10 AM

[Bill da Opt...:]

Excellent, accurate, article, Don.
I have 5000 shares of both FAS and FAZ.
FAS seems move 2X the move of FAZ.
They should be equal, yet in opposite directions.
I can't firgure that out.
And I fully agree - they are for Short Term Trades ONLY!
Bill in TN

Jul 10 09:28 AM

[Sovestor:]

Leveraged ETFs are sure recipe for disaster for those who don't know what they are doing.

Jul 10 10:33 AM

[Analyste de...:]

"Inverse and leveraged ETFs typically are not suitable for retail investors who plan to hold them for more than one trading session."


Leveraged ETFs are not only suitable for single trading sessions. They're efficient for trend trades, 3-6months in some cases. And why lump "inverse ETFs" with leveraged funds??

This is , we need to BLOCK whatever FINRA's nanny-state meddling looks like a backdoor attempt to restrict short sales or block access to short ETFs.

This should be vigorously opposed BY ALL ETF INVESTORS.
tinyurl.com/m42llx
Regarding Regulatory Notice 09-31, call FINRA directly 202-728-8472.

Jul 10 02:57 PM

[Gary Gallo:]

The leverage is controlled strictly by position size not the investment. Example, hold $300,000 of FAS`s holdings. Hold $100,000 of FAS. The risk is the same. A investment is only as risky as the dollar amount you put into it. Without money management any and all systems are doomed. I limit my exposure to 5% of the portfolio per trade, use stops and always have a good cash reserve.
The trouble with the reverse split on FAS & FAZ is you now have over $50.00 of risk, where a buy under $5.00 would give you just under $5.00 risk. Both with the same upside leverage. Sure you use a $5.00 stop. The risk here is you get stopped out and it goes to the moon without you.

Jul 10 06:50 PM

[nukldrager:]

Direxion's mission statement is very clear. Any talk of holding long positions is unnecessary. If the gov tightens up on this one, it's just another way of saying only our banker bosses can do this. It's sickening. Agree 100% with the comment above... any attempt to meddle must be blocked.

Jul 11 09:05 AM

[dmankoff:]

how are you short, just short the actual ETFs? or long puts?


On Jul 10 09:10 AM johnny inca wrote:

> I will be very sad if they pull the plug on FAS and FAZ because I
> have been running about 10% gains monthly by being short both. The
> reverse split was a huge bonus as it lowered the margin requirements
> for the position immensly, so thanks Direxion for that.

Jul 11 04:01 PM

[johnny inca:]

i am short both of the ETF's. I was trying to do it for months and then in April all of a sudden there was just a mass of availability of shares. Now that the reverse split has gone through you don't seem to be able to short them anymore, but I still have mine from april. The more volatile the trading the more you make on any given day. FAZ tends to decline more over time than FAS, so I try to stay short 40% FAS 60% FAZ. It's the closest thing to a sure winner that I have ever seen in my life.

Jul 13 03:37 PM

[kkerr:]

Shorting a bull ETF is still dangerous. In a strong enough uptrend with low volatility, leveraged bull ETFs can have significant gains. Thus, the short will be crushed.

Jul 13 04:36 PM

[johnny inca:]

kkerr, it is not fire and forget technology but it's still a sure winner if you know what you are doing.

Jul 15 03:59 PM