[Editor's Note: This article originally appeared on March 11, 2020.]
Leveraged and inverse funds are common in commodities, particularly in energy ETPs, where more than one-fourth of all available exchange-traded products (ETPs) use some leverage or inverse factor.
While leveraged and inverse ETFs can help traders exploit extremely short-term market movements, they definitely aren't for the faint of heart. Typically, their holding periods are on the order of days, or even hours.
But even a holding period that short can still burn you if you aren't careful—as some discovered during Monday's market sell-off.
On Monday, the VelocityShares 3x Long Crude Oil ETN (UWT)—which offers triple leverage on front-month WTI futures—tanked 73.8%, or just shy of the threshold set in its prospectus for automatic acceleration
UWT Just Barely Escapes Closure
Most ETNs have automatic termination, or "acceleration," clauses baked into their prospectuses. "Accelerating" an ETN means closure: Its due date is moved up, such that investors receive the note's closing indicative value in cash immediately (or almost immediately), rather than whenever the note was originally scheduled to close.
The most notable example of automatic acceleration occurred back in 2018, when the VelocityShares Daily Inverse VIX Short Term ETN (XIV) was shuttered after losing 96.3% of its value in a single trading day. At the time, the ETN held $1.9 billion in assets (Read: "Inverse VIX ETN Shuts Down").
UWT's prospectus specifies a 75% drop in iNAV from the previous day's value as the trigger for automatic acceleration. Monday's decline fell just 1.2% short.
Importantly, that 75% decline is not cumulative. As a leveraged fund, UWT's triple leverage factor resets at the start of every trading day.
And for whatever it's worth, the steep decline didn't appear to scare off traders. On Monday, UWT saw one-day inflows of $289 million.
Steep Declines in GUSH, GASL
Several other leveraged energy ETFs saw extreme declines on Monday, including the Direxion Daily S&P Oil & Gas Exp. & Prod. Bull 3X Shares (GUSH) and the Direxion Daily Natural Gas Related Bull 3x Shares (GASL). Both are ETNs offering exposure to their relevant commodity equities.
At its lowest point, GUSH had shaved 78.8% off its previous day's iNAV, while GASL had dropped 80.1%.
Those steep declines were still a few percentage points shy of the 90% drop allowed by GUSH and GASL's prospectus, however.
Neither GUSH nor GASL is an ETN, and therefore they aren't in danger of automatic acceleration, as UWT is. However, the funds' prospectus does acknowledge that if their underlying indexes were to fall more than 30% on a given trading day, then their triple leverage factor would mean that investors would lose all their money (Read: "How An ETF Can Drop 100% In A Day").
As such, GUSH and GASL's advisor, Rafferty Asset Management, has the management discretion to take steps to ensure the fund's portfolio won't respond to rises or falls in its underlying index beyond 30% on any one day.
In the case of GUSH, that appears to be exactly what happened on Monday, as the S&P Oil & Gas Exploration & Production Select Industry Index, the underlying benchmark upon which GUSH applies its 3x leverage factor, had dropped 34%.
Massive Reverse Splits Announced
On Tuesday, Direxion announced a 1-for-40 reverse split for GUSH, as well as a 1-for-10 split for the more broadly based Direxion Daily Energy Bull 3x Shares (ERX), and a whopping 1-for-100 split for GASL.
Reverse splits remove outstanding shares from the market while raising the price of the remaining shares an equivalent amount. For example, after the split goes into effect on March 23, one share of GUSH will be worth what 40 GUSH shares had been worth prior to the split.
This can help issuers and investors alike grapple with steep price declines, such as what happened during Monday's sell-off.
They're also a tactic used to avoid delisting from an exchange, which usually requires securities to meet minimum size and liquidity standards in order to trade.
Some iPath ETNs Not So Lucky
Reverse splits take time to implement, however, and there's no guarantee they'll go into effect in time to save a fund from delisting, especially if additional price drops occur.
For example, in late February, Barclays had announced reverse splits for the iPath US Treasury Long Bond Bear ETN (DLBS), the iPath US Treasury 10-Year Bear ETN (DTYS) and the Barclays Inverse U.S. Treasury Composite ETN (TAPR), after each had fallen significantly in value over the prior month and had developed substantial premiums to NAV.
The reverse splits were to go into effect on March 16, but Monday's wild trading session led to further price declines in the ETNs. By the end of the day, it was announced that they would be delisted from the Cboe BZX Exchange (Cboe is the parent company of ETF.com).
History Not Repeating Itself … Yet
As of the time of this writing on Wednesday morning, Monday's bloodbath in leveraged energy products does not seem to be repeating itself. UWT was down 12%, GUSH was down 18% and GASL was down 20%.
Of course, those securities had already seen such steep price declines that it's unclear how much further they had left to fall.
In any case, we'll be keeping an eye on them for any additional surprises.
Contact Lara Crigger at [email protected]