Direxion Ups the Ante with 3X International, U.S. Tech ETFs

by: SA Admin Jonathan Liss

3X Developed and Emerging International, U.S. Tech

Fresh off a Wall Street Journal piece suggesting many recent end-of-day spikes in equity trading have been a direct result of the rapid growth in leveraged ETFs, Direxion launched its follow-up batch of 3X ETFs Wednesday, each the first of its kind. The new funds offer investors triple exposure to two MSCI indexes covering Developed ex-U.S. (EAFE) Markets and Emerging Markets, as well as the Russell 1000 Technology Index.

The new ETFs appear below in grey; the non-greyed funds launched in early November and have already accumulated significant volume and assets in roughly six weeks of trading.

click to enlarge

* data courtesy of Direxion

Not for the Faint of Heart

Until Direxion came along, the term 'leveraged ETF' meant the aim was to provide investors and traders double an underlying index's performance, or double the reverse of its performance in the case of bearish funds. This leverage is achieved through the use of options, swaps and options on swaps. Direxion has upped the ante now with its 3X leveraged funds; this means the potential risks and rewards of being in one of these funds is amplified further.

Case-in-point: The ETF that tracks the MSCI Emerging Markets Index (NYSEARCA:EEM) is down nearly 48% in 2008. If that were extrapolated to Direxion's new 3X bull and bear funds tracking the same index, EDC and EDZ, the returns would be -144% and +144% respectively. (This is merely a theoretical exercise to make a point; leveraged funds aren't meant to provide an exact multiple-times return over such long periods of time.) It's the sort of volatility that makes for a Vegas-like atmosphere, not something anyone other than day-traders would generally tolerate.

Use in Longer Term Strategies

While Direxion's Marketing Director, Andy O'Rourke, admits the funds aren't aimed at 'buy and hold' types, he feels they can be very useful for longer term investors, though "this requires very active monitoring and constant rebalancing." O'Rourke clarifies a common misconception:

"The notion of '3X returns' is a misnomer. Leveraged ETFs are only supposed to provide accurate tracking on a daily basis. Longer term, the funds tend to overshoot or undershoot their stated goals so investors need to consider taking excess funds off the table, or adding in funds as needed to maintain their overall target allocations."

O'Rourke points out that 'compounding' occurred within the first two weeks of Direxion's original eight 3X funds launching, with seven of eight funds "overshooting their stated goal - by as much as 75% in one instance."

Tracking Error?

Longer term, leveraged funds often suffer from 'slippage', which lowers long-term correlations with underlying indexes. Seeking Alpha contributor David Merkel believes, "The higher the amount of leverage [an ETF] attempt[s] to replicate, the greater the amount of slippage they will experience versus their multiplied index. There is also slippage from rolling futures from month to month."

Such slippage could affect ProShares UltraShort Financials ETF (NYSEARCA:SKF), which attempts to provide double the inverse return of the Dow Jones U.S. Financial Sector Index. In a long-term comparison to iShares Dow Jones U.S. Financial Sector Index Fund (NYSEARCA:IYF) dating back to the beginning of 2008, SKF's returns are barely positive, while IYF is down roughly 51% YTD. Both funds track the same underlying index, albeit SKF does so in a leveraged inverse way through options and swaps, while IYF simply buys the index's underlying components on a one-to-one basis.

As the blips on the image below show, leveraged ETFs tend to overshoot their target both to the upside and downside, something swaps and options have the tendency to do when compounded under extreme trading conditions.

What the Future Holds

According to the prospectus [pdf file] filed by Direxion on October 1 of this year, the ultimate plan is to launch a total of 32 3X leveraged ETFs. Andy O'Rourke doesn't anticipate rolling anything out in the immediate term though. "We feel we're very well-rounded right now with yesterday's launch. We now offer two sets of domestic funds, two foreign funds and three sector-specific funds." O'Rourke expects to bring more 3X funds to market by the end of the first quarter but isn't eager to rush things. "We want to make sure we bring out the most appropriate funds at the most appropriate times."

Murray Coleman of Index Universe points out that in November, only four ETF providers "had greater net inflows than Direxion Shares." O'Rourke puts the total number of assets gathered at roughly $2 billion so far. This is impressive for six weeks' worth of trading; most first-time ETFs generally attract little fanfare and take significantly longer to build a genuine following. The ETFs charge 0.94% to 0.95% in expenses, roughly in line with ProShares' leveraged ETFs, but significantly higher than the 0.70% Rydex charges for its leveraged funds.

O'Rourke doesn't buy the argument put forth in the WSJ piece (referenced in the opening paragraph of this piece) blaming leveraged ETFs for recent end-of-day trading volatility. "The theory is accurate, but the magnitude just isn't there." According to O'Rourke, "the math doesn't work out" in terms of blaming leveraged ETFs, which he guesses comprise less than 2% of the total traded market cap on any given day. He thinks the late day volatility has a lot more to do with mutual and hedge fund redemptions. O'Rourke believes that, "It's possible some of the larger leveraged ETF issuers like ProShares, with $20 billion in assets are to blame in specific instances. In terms of Direxion, we have $2 billion in assets right now. Come back to us with that question when we get to $20 billion."

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