What Does EDZ's Pending Reverse Split Mean For Emerging Market Investors?

| About: Direxion Daily (EDZ)
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Emerging markets are an excellent way to gain global exposure and add calculated risk to one's portfolio. While the DOW (NYSEARCA:DIA) and the S&P 500 (NYSEARCA:SPY) are up 11% and 9% year to date, the most popular emerging markets trading vehicle, the iShares Emerging Market Index ETF (NYSEARCA:EEM) has been flat for a few months, down a slight 2.5% this year. Emerging markets carry risk versus more stabilized economies such as the United States. These risks include foreign exchanges rates, difficulty modeling and charting to predict cash flow, lax insider trading restriction, less liquidity, difficulty in some foreign companies raising capital, poor corporate governance, increased chance of bankruptcy and geopolitical risks. While vehicles such as EEM cover many countries, this risk is balanced compared to investing in specific jurisdictions. Still, there is inherent risk. One ETF that tries to capitalize in a leveraged fashion on this risk is the Direxion Daily Emerging Markets 3x Bear Fund (NYSEARCA:EDZ). Because EEM has been up in the last few years and has been flat for a bit, EDZ has degraded as it has been sold off and the investments made by EDZ management have not panned out. This has led to Direxion, a leader in providing popular alternative investment solutions, including other leveraged bear funds, to announce on March 1, 2013, that it will execute a reverse share split of the popular EDZ.

EDZ is a unique investment vehicle which "seeks daily investment results, before fees and expenses, of 300% of the inverse of the performance of the MSCI Emerging Markets Index." Under normal circumstances, EDZ management creates short positions by investing at least 80% of its assets in financial instruments that, in combination, provide leveraged and unleveraged exposure to the index. This split continues a line of reverse splits in bearish and volatility funds in the past few months, as the 4 year bull market continues to power higher with low volatility. A recent notable split was the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX), which underwent a 1 for 4 reverse split.

The reason for the reverse split is to make investment prices more attractive for buyers as Direxion wants to keep dollars flowing into the fund. Because emerging markets sector, have been very strong in the last few years and flat recently, EDZ as was on a path to zero. As EDZ leverages 300% against components of EEM, it is easy to see why the fund is losing on such investments, and in turn, its shares are not only sold off by investors/traders, but also readjusted lower week after week as emerging markets trade essentially flat. With large bets major components of EEM, EDZ has been crushed, down 46.5% in two years, trading at about $10.37 a share. In that same time, EEM index is also down about 11%. Clearly, EDZ is only useful for short-term trading as this bear fund is down 3x the amount of the EEM, which is also down. With this performance, EDZ was trading under $10.00, touching as low as $8.45 and thus Direxion is conducting the reverse split. None of the options products or holdings in EEM or other equities which EDZ management invests in will be affected by the reverse split, but some of Direxion's other products will be adjusted as well, a complete list which can be found here. The EDZ reverse split will be conducted at a ratio of one new share for every five held. The reverse split will apply to shareholders of record as of the close of the markets on April 1, 2013, and will begin trading at the adjusted price April 2, 2013. The ticker symbol for the fund will not change.

The reverse split will increase the price per share of the fund with a proportionate decrease in the number of shares outstanding. In a 1 for 5 reverse split, every five pre-split shares held by a shareholder will result in the receipt of one post-split share, which will be priced five times higher than the value pre-split share. (For example if you hold 100 shares of EDZ priced at $10.00 each, then after the reverse split, you will hold 20 shares valued at $50.00 each.) Thus, the reverse split does not change the value of a shareholder's investment. Again, the ticker symbol for the fund will remain the same even with the new change in price. The only change on paper for the fund is that it will be issued a new CUSIP number, which identifies the product on exchanges. There are two more considerations to think about during this split: what happens with fractional shares, and what happens to owners of options contracts?

The EDZ Reverse Split Could Result in Creation of "Fractional Shares"

For individuals holding quantities of shares that are not a whole number with an exact multiple of the reverse split ratio, the reverse split will result in the creation of a fractional share. This will affect any shareholder who does not hold a number of shares that is a multiple of five. After the reverse split occurs, fractional shares will be redeemed for cash and sent to your broker of record, generally within two weeks post-split. The annoying issue associated with such a move is that it forces shareholders to realize either tiny gains or losses, which could result in a reportable and taxable event for those shareholders, in addition to having a potential loss on investment if prices are below where they were purchased. Given the performance of EDZ in the last two years, a loss is quite possible in EDZ. While any loss or gain from a fractional share will, of course, be minimal, one way to mitigate the potentially taxable event is to purchase more shares to round out your EDZ holdings to a multiple of five, or to sell an appropriate number of shares to round out the holdings.

EDZ Options Contracts

Traders who may be holding options on EDZ should understand that this split will affect their contracts, albeit minimally. Once Direxion conducts the reverse split, the contract undergoes an adjustment that is commonly known as "being made whole", which means the option contract is modified accordingly so that options holders are neither negatively nor positively affected by the split. While we know the reverse split will adjust the price of the underlying shares of the EDZ option, the option will be adjusted so that the changes in price due to the split do not affect the value of the option. The options clearing corporation automatically adjusts the price to maintain the option market.

To get an estimate of what the new EDZ option will be worth, the calculation is simple. Each EDZ option contract generally is written for control of 100 shares of EDZ at some predetermined strike price. To find the new share coverage of the option after the split, all you do is simply take the split ratio and multiply by the old share coverage (normally 100 shares). To find the new strike price, take the old strike price and divide by the split ratio. Let's look at an example of a call option contract for 100 shares of EDZ at a strike of $5.00. Since the split is 1 for 5 we divide $5.00 by 1/5, generating a new strike price of $25.00. The option will now cover 20 shares because we multiply 100 by 1/5. Thus, your new call option contract (which will expire on the same day as originally scheduled) will be good for a purchase of 20 shares of EDZ for $500. On your brokerage account, the contract may be adjusted to read "EDZ1" or similar and still state it is worth 100 shares at the original price, but for redemption purposes, the contract would be redeemed for 20 shares at the post-split price.

Bottom Line

EDZ is down 46% in two years, currently trading at $10.37. Investors in EEM have had good returns in the last five years, but EEM has been essentially flat for some time now. With this price action, EDZ has steadily decreased. To bring the product to an investment price that Direxion believes is more attractive, it is conducting this reverse split. The reverse split of shares only really negatively impacts investors who own common shares at a total that is not a multiple of five, as they will be forced to sell fractional shares at a loss, or a potential gain, that could result in a taxable event. Owners of options contracts will not be affected aside from being faced with owning a new contract at a different strike price for a different number of shares. The total value of the contract will, however, remain the same.

Disclaimer: This article is not a recommendation to buy or sell EDZ, EEM or any other bear fund or volatility product mentioned in the article. It is for informational and educational purposes only. The options contract analysis can be applied to all splits of other companies in the future by utilizing the outlined calculations.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.