ETF Spotlight: TNA Amplifies Russell 2000 Performance

Small cap exchange traded funds just had their best week of the year and flows for the previously lagging market segment hit high marks. 

For aggressive small-cap bulls, the spotlight shines even brighter on the Direxion Daily Small Cap Bull 3X Shares ETF (TNA), which uses leverage to amplify the performance of the Russell 2000 Index. 

Prior to this week, small cap stocks, as measured by the iShares Russell 2000 ETF (IWM), had returned close to zero for 2024.  

By midday Thursday, IWM was trading more than 10% higher than its Monday morning opening price, and TNA was up 30%. 

What Is the TNA ETF?

TNA, or Direxion Daily Small Cap Bull 3X Shares, is an ETF designed to deliver three times the daily return of the Russell 2000 Index. This means it tries to mimic the performance of the index, but with magnified gains (and losses). 

Here's a breakdown of key points about TNA: 

• Focuses on small-cap stocks: The Russell 2000 Index tracks the performance of small-capitalization (small-cap) stocks in the U.S. 
• Leveraged ETF: TNA uses leverage to achieve its three times daily return target. This means it uses financial instruments to magnify the returns of the underlying index. 

Important Things to Consider About TNA

• Short-term instrument: TNA is designed for short-term holdings, not long-term investing. Due to compounding effects, holding TNA for extended periods may not deliver the expected 3x returns. 
• High risk: Leveraged ETFs like TNA magnify not just gains, but also losses. They are considered riskier investments than non-leveraged ETFs. 
• Not suitable for all investors: TNA is best suited for sophisticated investors who understand the risks involved and have a high-risk tolerance. 

How Leveraged ETFs Work

Leveraged ETFs like TNA amplify the daily returns of an underlying index or asset with financial instruments like futures contracts and swaps. Here's a breakdown of how they work: 

• Borrowing to magnify gains: Instead of simply holding the underlying assets, leveraged ETFs use borrowed funds to increase their exposure. This allows them to potentially achieve a greater return than if they only held the assets directly. 
• Derivatives for daily rebalancing: Leveraged ETFs use derivatives, particularly futures contracts, to achieve their daily targeted return. These contracts create obligations to buy or sell the underlying asset at a specific price on a specific date. This allows the ETF to constantly rebalance its holdings to maintain its target leverage ratio (e.g., 3x for TNA). 

Here's an example to understand leverage: 

Imagine you invest $100 in a stock that goes up 10% in a day. You earn $10. A leveraged ETF aiming for 2x daily return might use borrowing to essentially invest $200. With a 10% increase, it would earn $20. However, there are fees and other factors to consider, and the actual return might be slightly lower. 

SEC Derivates Rule 18f-4 Banishes New 3X Leveraged ETFs 

Three-times leveraged ETFs like TNA, as well as others issued by Direxion and ProShares prior to late 2020, can no longer be issued, according to a derivatives ruling from the Securities and Exchange Commission. 

SEC rule 18f-4, adopted Oct. 28, 2020, is a major update to the regulatory framework for how registered investment companies, like mutual funds and ETFs, can use derivatives. A key point of the rule uses Value at Risk (VaR) to limit a leveraged fund’s “targeted daily return to 200% of the return (or inverse of the return) of the fund’s underlying index.” 

In other words, 3X leveraged ETFs like TNA have been grandfathered in, and no more funds providing this degree of leverage or higher can be issued.  

Are Leveraged ETFs Like TNA Right for You?

The primary allure of leveraged ETFs is the potential to magnify returns on an underlying index or asset. If you believe the market will rise sharply, a 2x or 3x leveraged ETF can deliver significantly higher returns compared to a traditional ETF tracking the same asset. 

Some investors use inverse leveraged ETFs (designed to move opposite the underlying asset) as a hedge against potential losses in another part of their portfolio. 

The biggest risk of leveraged ETFs is that they magnify losses as well as gains. If the market goes against your prediction, a leveraged ETF can erode your investment much faster than a traditional ETF.