Alon Bochman, CFA's  Instablog

SumZero Writeup: 3x ETFs

This is not an original writeup, but I like the idea very much and I think SA readers would benefit from seeing it. And, as Picasso said "Good artists copy; great artists steal."

The idea is simple:
Take a pair of 3x and -3x ETFs, such as Direxion Daily Financial Bull/Bear 3X Shares (FAS & FAZ), and short them both. Both securities in the pair should lose value in the long term, and if you rebalance the position, you can maintain it to be pretty close to delta-neutral. The same idea should work with any pair of 3x ETFs, the more volatile the better.

Why would this work?
A 3x bull ETF has a daily exposure profile similar to 100% equity and 200% debt (the actual exposure is achieved using derivatives, but the effect is the same). This ETF tries to exactly triple the daily return of the underlying stocks it tracks. To do that, it tries to maintain this exact leverage ratio (1:2) throughout the day. What happens if the basket of underlying stocks it tracks drops during the day, say by 1%? The value of the equity drops to 99% and the value of the debt remains unchanged at 200%. The ratio is now 0.99:2, higher than the target. So the ETF will sell assets (stocks) and pay off debt (unwind derivative positions) until the ratio is back at 1:2. The ETF *has* to do this to keep its intraday tracking error to a minimum. The effect is locking in losses when stocks go down.

The opposite happens when the underlying stocks go up 1% intraday: The leverage ratio drops too low, the 3x ETF has to buy more assets (stocks) and take on more debt (increase derivative exposure). In other words, this bull ETF buys when stocks go up and sells when they go down. The bear ETF buys when stocks go down and sells when they go up. In both cases, it's exactly the opposite of what a value investor would try to do.

It gets worse, because the ETF may need to make multiple position adjustments throughout the day, depending on the volatility of the underlying. This increases transaction costs and taxable short term gains. That's why 3x ETFs have some of the highest expense ratios among ETFs.
 
We can see the value destruction in the price history of a FAS and FAZ:
On a 1-day scale, things look OK. FAS and FAZ are near-perfect mirror images:
finance.yahoo.com/charts?s=FAS#chart10:s...;range=1d;compare=faz;indicator=volume;charttype=line;crosshair=on;

On a 5-day scale, you can start to see a bit of degradation, note that on day 5, FAS is down a bit more than FAZ is up (10% vs. 9%)
finance.yahoo.com/charts?s=FAS#chart11:s...;range=5d;compare=faz;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=off;source=undefined

If we extend the timescale to about a year, giving the market more chances to change direction on a day-to-day basis, the funds inexorably lose more and more value. Bad if you're long. Good if you're short.
finance.yahoo.com/charts?s=FAS#chart8:sy...;range=1y;compare=faz;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=off;source=undefined


Multi-day example:
The example above discusses how an ETF maintains performance intraday. Let's look at what happens day-to-day: Let’s say the index of the underlying financial equities tracked by FAS starts at $100 on day 1, goes up 5% to $105 on day 2, then drops 4.76% on day 3 to end back at $100. So the underlying securities broke even. How did FAS do? On day 1, FAS went up 15% and ended at $115. Great. On day 2, it dropped 14.29% and ended at – wait for it - $98.57. Why not $100? Because the loss was applied against a higher starting balance. The reverse happens on the bear fund.

You can play with this scenario a bit and try different percentage gains and losses. The bottom line is, each day the market changes direction the securities lose money. The more volatility the market experiences, the greater the value loss experienced by the securities.

References
- If this sounds interesting, I would encourage you to read the more detailed writeup by casper719 on valueinvestorsclub.com (idea # 14325)

- How 3x ETFs behave in trending and non-trending markets: etfdb.com/2009/the-truth-about-3x-etfs-a.../

- More in-depth explanation of how (2x) leverage ETFs work. 3x ETFs work the same way. Not in particular the "constant leverage" section. seekingalpha.com/article/35789-the-case-...

- List of 3x ETFs: etf.stock-encyclopedia.com/category/trip...

- More 3x ETFs coming from ProShares: www.indexuniverse.com/sections/newsinfoc...



Disclosure: No position in FAS or FAZ