Financiers are crafty, and the creation of the rocket fuelled 3 times leveraged bull financial ETF and its evil twin the 3 times leveraged bear financial ETF, both products of Direxion Shares.  These creations have taken over the investment world.  Created just last year, already they are trading hundreds of millions of shares a day, putting them near or at the top of some very elite company.

A look at the prospectus of these funds,  if the average investor goes that far, starts to bring some questions about, namely "seeks daily investment results, before fees and expenses, of 300% of the price performance of the Russell 1000® Financial Services Index" Hrmmm, before fees and expenses.   Curiosity around the mechanics of the 3x leverage, kept me digging into these ETFs.  If you are so keen you can download the daily holdings, and most of it is pretty dull.  The majority of the list is just vanilla shares in companies included in the index, although there appears to be a lot less than the index itself contains.  Now, the magic of leverage comes from the largest holding in the fund: RUSSELL 1000 FINANCIAL INDEX SWAP.  By value, this instrument makes up 66% of the holdings.

The RUSSELL 1000 Financial Index Swap is a Total Return Swap and Direxion is pretty hush about the party (parties?) they are negotiating these swaps with.  The ticket is that although these swaps give you tremendous exposure to their underlying without making you pony up the dough, they are no where near free; usually they reside a percentage point or two above the interbank rate.  That cost, the cost of the swap, is what will gradually eat away at the value of these ETFs.

Ignorance will lead you to believe that since FAZ is bearish and FAS is bullish they should move inversely to each other.  They do to an extent, but it is not truly the case.  If you compare holding shares of FAS, and shares of FAZ assuming you bought at the open of the month, and sold at the close, you'd see returns like:

Month Long FAS Long FAZ
Jan 2009 -63.9% 43.5%
Feb 2009 -41.5% 12.7%
Mar 2009 22.8% -69.8%



Now, nobody in their right mind would hold these funds for a whole day, let a lone a whole month, and this timescale does demonstrate the erosion of capital that is happening.  Sure the upsides are multiplied, but the downsides are magnified even more, all because the swap that is underlying the fund is eating away at the value.  If investors were rational, and you had access to enough capital you could just short equal values of each fund and wait for that overnight rate + premium to eat away at the value.   Investors are not rational, however, and as these funds become more and more popular, more and more capital is made available to the manager to buy more swaps (and marketing).

With this knowledge in hand, why are these funds so popular?  They are liquid, the spread is tight, and the leverage appeals to the greedy part of the human mind.  If you are on the right side of the market, you can pull in 10 or more percent in a single day.  These funds do this crazy dance, day after day.  The average true range of FAS over the last 14 trading sessions is $1.51.  With today's close of $7.85 the average range the fund's price moves is almost 20% of it's current price.  That is a lot of volatility.  Take a look at the option premium charts:

FAS - Put premiumFAS - Put Premiums (click for larger)

FAS - Strike PremiumFAS - Call Premiums (click for larger)

If you can magically get the price half way between the bid and the ask, you could sell a straddle at $8 for about $2.85, or the $7 straddle instead for a credit of about $2.90.  That is a boat load of premium, because it is also a boat load of risk.  Option strategies laid ontop of a financial instrument based on return swaps.  Only disciplined traders who can execute within seconds of a movement should attempt to tread these waters, if you have a chance of being trapped in a meeting, or are not glued to your terminal, you'd be safer using proven strategies on a simpler financial index

[Post to Twitter] Tweet This Post