Direxion CEO discusses the proper way investors should view and use inverse and leveraged funds.
“Structure Matters,” by Dan Weiskopf, portfolio manager of Access ETF Solutions, examines issues about ETF structures in a series of interviews with ETF portfolio managers, index developers and other people who affect the structure of ETFs. The goal of the series is to highlight the different operating roles that individuals have that make the ETF structure work well for the investor.
Our series would be incomplete if it did not address the issue of leveraged and inverse ETFs. In this segment, we interview Daniel O’Neill, chief executive officer of Direxion Shares. Direxion today has about $7 billion in AUM, and its leveraged products were launched late in 2008.
Dan Weiskopf: You have two types of ETFs at Direxion: tactical ETFs and strategic ETFs. What do you look in an index provider when you’re trying to launch an ETF?
Dan O’Neill: Given the differences between these products, I have two different answers to that question.
For our levered and inverse products, we generally look at the one-beta market to see if the liquidity and asset size is substantial enough to support a levered product. In that part of the business, it’s the products rather than the indexes that are most important to us.
In the strategic space, our goal is to offer an ETF that has alpha over similar ETFs. We have four ETFs in this space, and we plan to grow this business.
Weiskopf: When we first met back in 2009, you made it clear that people interested in levered and inverse ETFs should take the time to understand how the products work, and you referenced your website as a repository of important educational materials. What areas of your website should people really be looking at today?
O’Neill: My basic advice is still the same—understand a product before you trade it. Levered and inverse products are different from strategic products. No. 1, they have leverage, which increases risk. The “bear” products also move opposite the indexes, which is different than traditional investment products.
Also, our tactical ETFs seek daily investment results—they are daily-beta products—which means their returns through time depend on the index path as much as the return for the holding period. We knew it was important that users, investors and traders, understood these different implications.
The daily-beta products are on a daily basis seeking levered returns, and that is not the same thing as seeking levered returns for a much longer period of time. People should understand the impact that volatility has on the return for our daily products through time.
Our website offers a number of white papers and tools that show the effects of compounding. We have what we call Direxion Shares Online University, which will test your knowledge of how the products work. It’s pretty comprehensive and self-paced.
We also have a tool on our website that shows the realized volatility for indexes that we use as benchmarks. Given the importance of volatility in these strategies, we think anyone involved in trading leveraged ETFs should take a look at this tool.
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.
Weiskopf: When you look at these past 12-month returns for the Direxion Daily Gold Miners Bear 3X (DUST), the Direxion Daily Gold Miners Bull 3X (NUGT) and the Market Vectors Gold Miners (GDX | A-61), if you held them throughout the whole year, you actually would have lost money in all three products, despite the index being down 35 percent.
O’Neill: The one-beta ETF—GDX—was down approximately 37 percent for the year ended March 31, 2014. Our levered bull ETF—NUGT—lost almost 88 percent, which is a large loss and not surprising given the loss for GDX. Our levered gold bear ETF—DUST—had a very slight gain. It did not have larger gains because it was impacted by the volatility of the index rather than just the returns of the index for the 12 months.
Gold miners experienced very high volatility last year and continue to. It’s a fast-moving sector—large moves and reversals from day to day. It’s a trader’s market much more than an investor’s market. It’s moving too quickly to hold, at least in a levered product.
Again, however, I find evaluations of the performance of a daily-beta ETF for a year to be academic and beside the point. Hopefully no one held the products for anything approaching a year and the performance of the funds for a year does not describe our traders’ experience with the products, which tends to be for days or weeks.
The media loves to do what you have just done and imply that something is wrong, when there is nothing at all amiss. Shares in DUST have average turnover of around 50 percent per day—meaning volumes are equal to half of assets. Looking at performance for a year is not at all descriptive of how the product is used.
Weiskopf: You mentioned something about that your products can’t go to zero. The reason is that, structurally, based upon the math, they just can’t?
O’Neill: To go to zero, a fund would need to experience a negative move in one day of greater than 33 percent. It’s unlikely, but it could happen. I should also point out that because of stock exchange rules and otherwise, the major indexes should never move more than a certain percentage on a daily basis.
As you get into more esoteric indexes, you could have greater volatility and greater single-day moves. But what we’re looking at is single-day moves. I hope an index never moves that drastically. Even if a fund never goes to zero, the fact is that the products are risky, and the real issue is that you can have huge losses when you invest in these products.
On a long-term basis, levered products can and have experience massive losses. FAZ, as an example, has seen huge moves go against it, which has caused multiple reverse splits. We hope people as prudent investors have been educated to not look at these ETFs for long-term positions, but for purposes of example, for this interview, a holder from 2009 of FAZ may have lost about 99 percent of their investment.
Weiskopf: Which goes back to the prospectus as well. Is there a section in the prospectus that highlights the volatility analysis?
O’Neill: There is all sorts of information in the prospectus about how the funds work and the risks associated with them. These are risky products, and investors should not buy them unless they know how they work.
There are volatility tables in there, there are graphs showing you what happens if market volatility is high and how you’ll experience decay associated with daily compounding. The prospectus is full of risk factors. People should read them.
If you read those risk factors, what you begin to realize is you should never buy one of these products and go away for three months. That is not the way you use these products. If you’re unwilling to give them some attention on a daily or at least weekly basis, you shouldn’t use the products.
Weiskopf: How do you think people should trade these in the context of implementing the trade? The trader says, “OK, I want to be long FAS.” Market order?
O’Neill: I think the type of order is dictated by the product, the market and it depends on the day. People should look at the volatility, look at the liquidity and if they see something that is penny-wide, they can put in a market order for a few hundred shares.
If you’re buying a product that has spreads that are wider than a penny, and if the product is newer or just doesn’t yet have the kind of liquidity that the big levered ETFs have, then I would definitely use a limit order.
But I think traders should recognize that they’re in control. If a market is deeply liquid and it’s trading penny-wide, market orders are probably fine. If it’s not the case—and this isn’t true just for levered ETFs, it’s for anything—they should also pay attention when markets are open and be very careful with market on close orders or the open.
Traders need also to check normal volumes relative to their order. It’s not that the order can’t get done seamlessly, but people need to know there are special traders or market makers on these securities whose job is to facilitate trading on a profitable basis to them.
Weiskopf: Thanks, Dan. I feel like I have a new friend and his name is vol, but clearly he’s hiding for now. Careful for what you wish for!
Dan Weiskopf is a portfolio manager of Access ETF Solutions LLC, whose third-party ETF strategies are offered through IPI Wealth Management, Inc. (IPI). At the time of release, the Access ETF Solutions Tactical Fixed Income model portfolio’s owned the Direxion inverse 20-year Treasury ETF (TYBS). This strategy is designed to mitigate against the impact of higher interest rates through tactical investing.IPI is an SEC-registered investment advisor, with its principal office located at 226 W. Eldorado St., Decatur, IL 62522, 217-425-6340. Access ETF Solutions LLC was established in 2013 with a focus that structure matters in selecting ETFs. Access ETF Solutions LLC is not affiliated with IPI.
References to specific securities or market indexes are not intended as specific investment advice. This interview should be viewed as an educational piece. All interviews have been approved for release by the individual and the individual’s affiliated firms and the information is for institutional investors only. Readers are advised to read the full transcript of the interview including disclosures at http://accessetfsolutions.com/ or contact Dan Weiskopf at 212 628-4882.