Phorgy Phynance

Archive for April 2009

Bloggers Missing it on Leveraged ETFs

with 4 comments

Back in December, I noticed several bloggers coming out against leverage ETFs. In response, I wrote

Leveraged ETF Math

to try to dispell some of the misunderstandings out there. Last week, Bespoke Investment Group, whom I generally admire, came out with an article:

Direxion 3x Financial ETFs Go Certifiably Crazy

The volume on Direxionshares’ 3x leveraged bull and bear financial ETFs shows that traders love the product.  However, the ETFs have returned some crazy numbers this year.  The 3x ETFs provide 3 times the daily change of the underlying index, and year to date, the financial index that FAS (long) and FAZ (short) track is down 14%.  However, the 3x long ETF (FAS) is down 68% year to date, but the 3x short ETF (FAZ) is down 65%!  And since the lows on March 9th, these things have returned some whopping numbers.  FAS is up 195%, while FAZ is down $102.78 (or 87%).  Rest assured that a lot of people have gotten burned with these leveraged ETFs, and even though they’re meant to track daily performance, their crazy longer-term returns won’t go unnoticed forever.

There is nothing crazy about the long-term returns of FAS and FAZ. The proper way to compare their performance is versus an index whose daily returns are exactly three times the unleveraged index. This is easy to do once you have the daily returns of the index. Here is the cumulative performance of FAS vs 3x the daily return of the Russell 1000 Financial Services index:

Source: Bloomberg, Yahoo! Finance

Here is the cumulative performance of FAZ versus -3x the daily return of the Russell 1000 Finance Services index:

Source: Bloomberg, Yahoo! Finance

I don’t think anyone can look at these charts and suggest Direxion is not tracking the indices well. Instead of spreading misinformation, perhaps it would be better if bloggers tried to explain these ETFs rather than set up strawman charts indicating how different cumulative returns of FAS and FAZ versus the cumulative return of the index. Of course with daily returns of 40%, the difference between cumulating 3x daily returns can deviate significantly from 3x the cumulative returns. This is perfectly normal and anyone investing in leverage ETFs should understand this. There is nothing “certifiably crazy” about it.

Direxion had the misfortune of introducing these ETFs during a financial crisis. Here is what the hypothetical cumulative performance of FAS would have looked like if it was around since 1995:

Source: Bloomberg

During bull markets, these ETFs suddenly do not seem so unattractive over long periods.

Disclosure: I own shares of BGU as a long-term investment. Let’s see where it is trading 3 years from now.

Written by Eric

April 11, 2009 at 11:05 am

Posted in ETF, Leverage, Leveraged ETF

Tagged with , ,