Weiskopf: You've talked a little bit about counterparty risk. How do you manage your swaps?
O’Neill: We have six different swap counterparties, each of which is a large securities firm. Our custodian is the Bank of New York. We use tri-party agreements with each of our counterparties and the Bank of New York, which allows us to post collateral for our obligations with Bank of New York rather than the counterparty.
Each night, we look at the mark-to-market, and move money back and forth so that we remain in control of our assets. Having segregated accounts at the Bank of New York is really a key issue in working with counterparties.
Weiskopf: I periodically get calls from people looking to create a trade where they are short both sides [leveraged and inverse] to capture the natural decay. I question whether they can get the borrow at a reasonable price and maintain the borrow. Do you get similar calls and have an opinion on whether the strategy makes sense?
O’Neill: These are sophisticated volatility trades that should not be considered by most investors. In essence, daily-beta products are momentum products—they respond to gains by increasing exposure and respond to losses by decreasing exposure. In a volatile market, this leads to losses because the strategy results in the portfolio being “whipsawed” by changes in the benchmark direction.
In a nutshell, if you buy a pair of levered index products in equal dollar amounts at the same time, you’re going short volatility because you’re betting the gains in one fund will outweigh the losses in the other. If you short a pair in equal amounts at the same time, you’re going long volatility because you’re betting the losses in one will be greater than the other. These are volatility trades rather than equity trades.
In very-high-market volatility, like from when we launched in late 2008 through March of 2009, volatility was very high, and being short a pair of levered ETFs was likely to have been very profitable. This would be true with Direxion Daily Financial Bull 3x (FAS) and Direxion Daily Financial Bear 3x (FAZ), our largest ETF pair. Both ETFs were down, so being short the pair would have been profitable.
However, over the last several years, volatility has been much lower. The benchmark for FAS and FAZ rose significantly, and FAS has had very large gains that have more than offset the losses in FAZ, so being short the pair would have led to large losses. I think these sorts of observations are more academic than practical because I do not believe—nor we would encourage—anyone hold the products or pairs of the products for periods as long as those we are discussing.
We are supportive of the create-to-lend market, which is when people are looking to borrow, you need to have someone to lend you those shares. Getting the borrow can be a challenge, because the people who are using our products tend not to be willing to commit to lend them, and that’s appropriate because they might be out of the trade in three days. And so because the nature of the product is short term, the ability to lend it is also very limited, and so the borrow tends to be expensive.