Direxion Daily Financial Bull/Bear 3X Shares FAS & FAZ S W
August 09, 2009 - 8:38pm EST by
2009 2010
Price: 76.09 EPS NM NM
Shares Out. (in M): 23 P/E NM NM
Market Cap (in $M): 1,720 P/FCF NM NM
Net Debt (in $M): 0 EBIT 0 0
Borrow Cost: NA

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This write up is short and hopefully sweet because the thesis is simple. Leveraged ETFs, while providing investors with the ability to make daily enhanced directional bets, have inherent flaws in them that cause the value of them is in a state of perpetual decline, regardless of the greater market movements. I'm sure most people know just how flawed these ETFs are but I have yet to see an investment thesis lined up on how to profit from the flaws in a close to risk free, delta neutral manner. There's just a tremendous opportunity to take low-risk and receive high returns off of the ETFs while they are still so widely held and available to short. The focus of the analysis is on Direxion 3X leveraged ETFs principally because they operate with the most leverage of any ETFs out there.

The prospectus is pure gold as it lines up the thesis effortlessly.

From the prospectus:

"For the Bull Funds, Rafferty (Rafferty Asset Management) attempts to magnify the returns of each Bull Fund's index or benchmark for a one-day period. The Bear Funds are managed to provide returns inverse (or opposite) by a defined percentage to the return of each Bear Fund's index or benchmark for a one-day period."

"At the close of the markets each trading day, each Fund will position its portfolio to ensure that the Fund's exposure to its benchmark is consistent with the Fund's stated goals. The impact of market movements during the day determines whether a portfolio needs to be re-positioned. If the target index has risen on a given day, a Bull Fund's net assets should rise, meaning the Fund's exposure may need to be increased. Conversely, if the target index has fallen on a given day, a Bull Fund's net assets should fall, meaning the Fund's exposure may need to be reduced. If the target index has fallen on a given day, a Bear Fund's net assets should rise, meaning the Fund's exposure may need to be increased. A Fund's portfolio may also need to be changed to reflect changes in the composition of an index. Rafferty increases the Fund's exposure when its assets rise and reduces the Fund's assets the Fund's exposure when its assets fall."

QED: The ETFs buy when stocks go up and sell when stocks go down to keep the leverage of the ETF at its predetermined 3X leverage, a surefire way to value destruction. The volatility destroys value.

I think my favorite table from the prospectus is the one below. It shows how much the funds degrade in value when there is volatility. This is truly the heart of the thesis.

Source: Company Reports

The prospectus goes on to say in the next paragraph: For a period longer than one day, the pursuit of daily goals may result in daily leveraged compounding, which means that the return of an index over a period of time greater than one day multiplied by the Fund's daily target generally will not equal a Fund's performance over that same period.

The example: Two funds...1 Traditional ETF(Fund A), which seems to match the performance of XYZ index and 1 Leveraged ETF (Fund B), which seeks to match the daily leveraged investment results that correspond to 300% of the daily performance of the index.

On Day 1, the XYZ index increases in value from $100 to $105, a gain of 5%. On Day 2, the XYZ index declines from $105 back to $100, a loss of 4.76%. In aggregate the XYZ index has not moved. An investment in Fund A would be expected to gain 5% on day 1 and lose 4.76% on Day 2 to return to its original value.

The same $100 investment in Fund B, however would be expected to gain 15% on Day 1 (300% of 5%) but decline 14.28% on Day 2. Although the percentage decline is smaller on Day 2 than the percentage gain on Day 1, the loss is applied to a higher principal amount so the investment in Fund B has a loss even when the index value has not declined. (These calculations do not include the charges for expense ratio and the financing charges.)

Source: Company Reports

QED: There are inherent flaws in the compounding of the ETFs returns.

Now, let's look at the returns of these ETFs over time. The Financial Bear and Bull ETF are the poster child for the flaws. The Bull is down 44% YTD and the Bear is down is down 92.22%.

Source: www.morningstar.com

Source: www.finance.yahoo.com

Lets not forget the expenses to the fund. 2-3%+ per annum will help the fund slip even further.

Ways to play the trade:

1.       My favorite: Short both the bull and the bear fund and rebalance the positions regularly. This effectively hedges the delta and you buy volatility for free. The degradation of each fund is its own catalyst.  The more volatility, the more money you make in a low risk manner.

2.       If you are bullish on the stock market, short the bear, as it will go down much more than the market will go up but won't go up as much if the market does go up.  The fund will inherently degrades as well even if the market goes down, so it's a win-win, although not nearly as low risk as #1.

3.       If you want to hedge your long positions, short the bull. If the market tanks, this fund will get clobbered. Even if the market continues going up, it won't go up as much as the degradation of the fund will be at works.


(1)     No shares available to short, position gets called. You don't lose money if you play the trade right though.

(2)     Cost to short rises. Currently it is 5%-10% at Interactive Brokers for the Financial Bear/Bull funds.


Volatility greater than 0%

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