Andy O'Rourke says the nuances of intraday trading and the impact of compounding in leveraged ETFs need to be fully understood.
Just four ETF companies took in more net new cash in November than DirexionShares. Its Large Cap Bull 3X Shares have been among the most heavily traded NYSE Arca stocks lately. IU.com's Eric Rosenbaum recently spoke with Direxion Funds' marketing director Andy O'Rourke about the rapid rise to ETF prominence and how the fund company can keep the momentum up.
IU.com: Is the company surprised by how quickly the market embraced the 3X approach?
O'Rourke: As of Dec. 12, we surpassed $800 million in assets. We were at least somewhat surprised that the response has been so positive. We hope that demand stays where it is, and we have every reason to believe it will, but we won't consider the ETFs an absolute success until their longevity is proven.
IU.com: Were there a lot of naysayers, predating the launch, who said with 2X leverage products in the market, enough was enough?
O'Rourke: The big question was about existing products out there offering leverage at 2-to-1, and to some people, that seemed plenty. The question asked was, would the market see these shares as that different from 2X leverage ETFs, or would investors be scared away and feel that the shares hit the point of too much leverage? ProShares has had a tremendous amount of success and will continue to. We never thought of our entry in terms of cannibalizing anyone else's business, either.
IU.com: Some advisors make the case that if you don't have advanced computer systems trading in fractions of seconds, as an average investor, you should not go near funds like these. Do you agree with that perspective, or can you make a case that 3X leverage ETFs can be used by average investors?
O'Rourke: Should an individual investor be buying these funds just to try them out? No, definitely not, and we are the first to be vocal about that. The nuances of intraday movement in these ETFs and the impact of compounding over longer time periods are phenomena of leveraged investing that have to be understood. These funds have daily objectives, and they have been meeting those, but if you invest over a longer period of time, your objective versus that daily objective can get seriously out of whack. We understand that there are investors in these ETFs who may not have full understanding, so we have really been communicating via email campaigns in the early days.
IU.com: Can you provide an example of the compounding issue that already occurred with the ETFs and that you have been proactively communicating to investors?
O'Rourke: This is less relevant to those trading intraday, but a few weeks after the ETFs launched, we realized there were substantial excesses in most of the funds, especially on the bear side. We began an email campaign to let investors know about the activity and how the ETFs returns were deviating from the indexes. From inception to two weeks later, there were excesses of 76% in the case of the Financial Bear 3X Shares. That's a wise time for investors who know what they are doing to take earnings off the table and not "let it ride." In fact, when we looked again two weeks later, almost all that excess return was gone. Investors need to understand these fluctuations can and do happen with leverage ETFs. For investors to align their goals with 3X beta for periods of greater than one day, they have to be regularly thinking in terms of reallocating.
IU.com: What types of investors have been the primary users of the DirexionShares so far?
O'Rourke: Certainly, institutional traders and hedge fund managers have welcomed our funds, as have active investors in the advisor community. For institutions and hedge funds, it is partially because leverage has become more difficult to obtain. These ETFs are a simplified way to get leverage without a margin account and no margin calls. Institutional traders who understand how these ETFs work and hedge fund managers are used to trading products with much more leverage than exist in our ETFs.
IU.com: How much of the early success has been due to the extreme volatility and intraday opportunities, and how will the company keep up momentum when the markets become more normal?
O'Rourke: There have been successful intraday trading strategies, but also investors maintaining assets overnight. It is a valid point though, that the markets are so volatile now that our 3X leverage ETFs have provided a mechanism for day traders to profit from large intraday swings.
As markets normalize, investors and traders may consider using the ETFs in the more traditional way that they have used our existing mutual funds. With markets as volatile as they are now, it is difficult to let a hedged position last for longer than a very short period of time. We want these ETFs to be thought of as portfolio tools rather than day-trading vehicles. The ETFs have applications in hedging an overall portfolio, and in providing leverage for portable alpha and long-short relative value trades. Active investors recognize how to use these leveraged ETFs to free up capital and diversify further, and for longevity, it will be important for them to return to using ETFs with more of those strategies.
IU.com: How do the open-end mutual funds using similar strategies fit into your overall growth strategy?
O'Rourke: The ETFs will grow but the mutual fund space will not go away completely, especially when you look at issues like the retirement market and the relative infancy of ETFs there. Also, there are particular long/short strategies we will continue to innovate with on the traditional fund side of the business, especially in the area of alternative assets, like the commodity long/short fund we launched during the summer. We have just filed for a similar long/short financials fund. We raised more assets in our commodities fund tracking the S&P Commodity Trends Indicator Index than ELEMENTS ETNs raised in its exchange-traded note tracking the same index.
IU.com: Direxion Funds is in the process of liquidating seven of its traditional funds. Is that related to the ETF success?
O'Rourke: Our ongoing liquidation of seven funds from the traditional side of the business is partially related to the ETF launch. At a basic level, there is a crossover point in terms of profitability with leverage and inverse funds where the trading costs in small funds can outweigh profits. At a macro level, we are pruning the traditional lineup of funds because now that we have ETFs, we want to be as nimble overall as possible in terms of profits. We don't want any deadweight, and these were all small funds.
Also, a few of the liquidated funds were targeting Japan and India, and we plan on having a greater focus on international in our ETF lineup. We have registered for bull and bear India ETFs, and also bull and bear China ETFs. While those traditional funds were small, we are optimistic about country-specific portfolios in the ETF space. The viability will come from actively being able to trade both sides. I think ProShares has more than 50% of their assets in international.
IU.com: DirexionShares has a slew of international ETFs filed, as well as sector ETFs. Will the international ETFs be the next to launch?
O'Rourke: Yes, the 3X international index ETFs will be next to launch. I can't say which ones, but before the end of the year there will be a handful more on the international side. Everything we offer in ETFs is domestic right now, and since we now have a footprint in domestic, we want to see how well our ETFs trade on international indexes.
IU.com: You've upped the ante to 3X leverage. Some advisors have told us that their computer systems can trade effectively at 5X leverage. How high can it go? Is 4X, 5X leverage on the horizon?
O'Rourke: We have no plans to go there at any point. To some degree, you get to a point where market volatility makes pushing the envelope further with leverage a mistake. In any given day if an index is down 33%, someone investing money in one of our funds would be down to zero. That's not terribly realistic with market structure like circuit breakers, but it's plausible. So if you reached the point where the market only needed to drop 20-25% to take an investor's assets to zero, then that might be too much.