TYD: Not Quite What I Expected Of This Leveraged ETF

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About: Direxion Daily 10-Year Treasury Bull 3x Shares ETF (TYD)
by: D.M. Martins Research
Summary

In this article, I touch upon the hotly-debated topic of leveraged ETFs, and review the Direxion Daily 7-10 Yr Trs Bull 3X ETF.

TYD should never be used by long-term investors as a buy-and-hold instrument, right? Not so fast.

I share with readers a few important conclusions after having put TYD's near 10-year performance under the microscope.

I have been holding the Direxion Daily 7-10 Yr Treasury Bull 3X ETF (TYD) in my primary portfolio for nearly two years now. Today I take a look back, make an assessment and share with the readers some of my key observations about the fund - one that I have been using since the start of 2017 as an instrument to help me execute my multi-asset class, diversified portfolio strategy.

Image result for leveraged etf image

Credit: Barron's

What is it?

TYD is a three-times leveraged, intermediate-term treasury returns fund. What this means, as defined (probably better) by the management company itself, is that the ETF "seeks daily investment results, before fees and expenses, of 300% of the performance of the ICE U.S. Treasury 7-10 Year Bond Index." The fund tries to accomplish this goal not by primarily and passively holding government bonds, but instead by seeking exposure to the daily returns of treasury instruments of the desired maturity through futures (derivatives) instruments.

Direxion provides quite a bit of information that sounds very much like disclaimers and warnings in the ETF's prospectus. This is probably done to ensure that investors understand the objectives and the mechanics of the fund as much as possible. Here are a few that I find highly relevant:

  • TYD "may be riskier than alternatives that do not use leverage because the fund's objective is to magnify the daily performance of the (benchmark index)."
  • "The return of the fund for a period longer than one trading day will be the result of each trading day's compounded return over the period, which will very likely differ from 300% of the return of the index for that period."
  • "The fund is designed to be utilized only by knowledgeable investors who understand the potential consequences of seeking daily leveraged investment results, understand the risks associated with the use of leverage, and are willing to monitor their portfolios frequently."

The second bullet above is particularly interesting (and will become the focal point of the next segment below). Said plainly, it claims that the annual returns of TYD will more than likely not be three times the annual returns of the benchmark index - except in the case of zero volatility in the index's daily performance, which is virtually impossible. In fact, Direxion provides the following, somewhat scary table to illustrate what the annual returns of the ETF might be, given different index return and volatility scenarios.

Source: management company's summary prospectus

Notice that, in theory, TYD may produce negative annual returns even if the index is up for the year. In the extreme case of a 100% annual volatility rate (farthest right column above), TYD is expected to lose anywhere between virtually all its market value to nearly 80% of it - regardless of how the index performs in the year.

The table above, however, seems to me more hypothetical than practical, since we are talking about the fairly stable returns of seven- to 10-year treasury bonds. As Direxion itself presents in its prospectus, "the index's annualized historical volatility rate for the five-year period ended in December 2017 was 1.52%. The index's highest volatility rate for any one calendar year during the five-year period was 6.48%."

It's true that (1) the 2012-2017 period was a pretty quiet one for treasuries in general, (2) volatility (measured in terms of one annualized standard deviation) for a shorter period of time may have been higher than the annual readings, and (3) future results can be very different from past performance. Still, I expect that, on a before-fee and expense basis (very importantly, make a mental note of this for later), the returns of TYD should very much approximate those of the index multiplied by three - even over a long period of time.

Not what I would have expected

Having covered the basics, let me present the historical performance of TYD since the day I bought shares for my portfolio, back in early January 2017. One observation caught my attention immediately.

Intuition, at least, suggests that TYD would likely be best suited (if at all) for short-term traders who intend to make a quick bet on the price movement of intermediate-term treasuries and close out their positions by end of day. In fact, I have heard multiple cries by many trading and investment experts claiming that leveraged ETFs should not be touched by longer-term investors with a 10-foot pole.

The reader may, therefore, be surprised to learn that TYD's daily returns, deleveraged by a factor of three (in other words, daily returns divided by three) have not had a very strong correlation with the daily returns of the ICE bond index: Only +0.63 (remember that +1.0 means perfect positive correlation, while zero means completely uncorrelated performance). In this case, I'm using the iShares 7-10 Year Treasury Bond ETF (IEF) as my proxy for the index, since it tracks the same benchmark without applying any extra leverage.

The graph below illustrates my observation.

Source: DM Martins Research, using data from Yahoo Finance

Notice that IEF has produced, since the start of 2017, positive or flat daily returns 240 times. Coincidentally, it also has dipped below zero on 240 trading days. But TYD did better: 283 up or flat days vs. only 197 down days. In fact, IEF and TYD produced daily results that were directionally consistent (in other words, positive in both cases or negative in both cases) only 73% of the time.

The phenomenon seems a bit odd, since leveraged ETFs in general are thought by many to be day-trading instruments - while TYD seems to have failed at being a good one over the past 23 months. I have identified a couple of reasons that could explain the mismatch:

  • Liquidity: IEF, being a popular ETF, has traded an average 2.6 million shares per day since January 2017. On the other hand, only 1,600 shares of TYD exchanged hands per day on average during the same period. More importantly, one of every five trading days did not register any transaction. When this happens, the price of TYD does not update, making a daily mismatch against IEF more likely.
  • Premium to NAV: TYD is traded in the market as an standalone instrument. However, the ETF's closing market value may not always reflect precisely the value of the underlying securities in the fund - known as NAV, or net asset value. Per Direxion's website, TYD has traded at a premium to NAV more often than not: 65% of the time over the past 90 days, vs. 35% of the days at a discount (see graph and table below). While these discrepancies tend to correct themselves over a few days, they may explain why the daily performance of TYD may look superior than expected.

Source: Direxion's web page

Given the above, it looks like TYD might be a useless ETF for both long-term investors as well as for short-term traders... right?

Not so fast.

To start, I tested a hypothesis that the correlation between the weekly returns of TYD (deleveraged) and IEF might have been stronger since January 2017 than that of their daily returns. In my mind, this could be the case if the day-to-day pricing discrepancies probably driven by low liquidity and NAV premiums end up correcting over the course of two or three trading days.

To my satisfaction, the correlation between the weekly (not daily) returns of TYD and IEF was much higher, at nearly 0.9. The graph below illustrates that both funds have achieved positive and negative weekly returns a bit more consistently, even if not perfectly. In nearly 90% of the trading weeks, both TYD and IEF were up or down in synchrony, compared to only 73% of the time in the case of daily returns.

Source: DM Martins Research, using data from Yahoo Finance

Lastly, I decided to test TYD's efficacy at producing three times the returns of the index over a long period of time. I understand that the warnings against being a buy-and-hold player in leveraged ETFs are plentiful. But I'm a contrarian investor at heart, and would not miss out on the opportunity to test these dearly-held assumptions.

To do so, I went back to TYD's inception date of April 2009. Then, I ran two different comparisons: TYD vs. IEF with and without adjusting for net management fees and expenses. It's worth noting that TYD, perhaps due to the more complex nature of the fund, is a much more expensive ETF than its plain vanilla, unlevered treasury counterpart: 1.09% per year vs. 0.15%. The graphs below illustrate my findings.

Source: DM Martins Research, using data from Yahoo Finance

As it turns out, TYD has done a superb job over the past 10 or so years at producing three times the long-term returns of its intermediate-term treasury index. As the above suggests, fund expenses (and not a fundamental flaw in the design of leveraged ETFs) seem to have been the main factor creating somewhat of a drag on TYD's performance vs. my original expectations for returns that "should very much approximate those of the index multiplied by three."

Parting words

Very counter intuitively, and even contradicting the disclaimers on Direxion's own prospectus, this leveraged ETF has been a much more effective buy-and-hold instrument for long-term investors since inception than it has been a decent day-trading tool. The feared impact of volatility drag (e.g. sharp negative returns even when the index moves up or sideways) has not materialized to a great extent, so far.

Granted, bonds experienced little in terms of a roller-coaster ride until 2017, as interest rates remained very low following the Great Recession of 2008. But even during and just after the January to March 2018 bond correction period (left and right graphs below, respectively), the increased volatility in treasury prices was not enough to throw off the multi-day performance of TYD vs. the index.

Source: DM Martins Research, using data from Yahoo Finance

Following my analysis, I reach a few important conclusions:

  1. Leveraged ETFs can be tricky to comprehend.
  2. But contrary to popular belief, buying and holding (vs. trading) leveraged ETFs is viable, even if the strategy might pose some risks that should not be ignored.
  3. Asking questions and testing assumptions is a much better approach than blindly trusting "experts" who may quickly reach conclusions without performing much due diligence or analysis - I encourage readers to do their own, whenever and as much as possible.

Disclosure: I am/we are long TYD. 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.

Additional disclosure: Those interested in exploring TYD a bit further and, eventually, even buying shares of the ETF should read the fund's prospectus in full. This article is not intended to be the sole (or even the main) source of information for investors to perform proper due diligence.