3x Leveraged ETFs Throw Rocket Fuel on the Fire

Market-timers rejoice! Today, Boston-based Direxion officially launched the first group of exchange-traded funds that offer triple leverage, or 300% exposure to market indexes to make bullish or bearish bets. With excessive financial leverage at the heart of the current credit crises, the timing of this launch may surprise some. Over the past several months market participants have experienced unprecedented levels of volatility. With a dynamic regulatory environment, blitzes of weak economic data, credit markets that have yet to fully thaw, and uncertainty surrounding the new administration, it seems as though volatility may remain for some time. For investors looking to magnify market returns with these aggressive products, we can offer some simple advice: Hold on to your hats.

In all seriousness, we do think that these 300% leveraged ETFs can be powerful and effective tools to speculate on the market's daily movements--if used properly. However, they can also be very detrimental to an investor's financial health if used without caution. In our view, these products should be viewed as hedging and speculation tools that are better suited for use by professional investors. For instance, an institutional investor seeking to hedge his exposure to oil could theoretically do so by using one third of the capital. The investor could then deploy the extra capital afforded to him by the 300% in other investment opportunities. The leveraged inverse ETFs can make sense from a risk management perspective as well: An investor can't lose more than his or her initial investment with these products, while in a traditional short position one would theoretically be exposed to unlimited losses.

The 0.95% expense ratio that the funds charge is typical of what's out there for other leveraged and alternative exchange-traded products. However, we'd be wary of hidden expenses that could arise in the form of market impact costs. Because these products are in their infancy and Direxion is a new player in the ETF landscape, it will be interesting to observe how the ETFs are received by investors (and traders). Potential investors should keep an eye on whether the products attract adequate levels of assets under management and average daily trading volumes to support normal trading.

Potential liquidity issues or extraordinarily wide bid-ask spreads could threaten the viability of these products. After all, if an institutional investor or hedge fund manager wants to speculate (or hedge exposure) on daily market movements, then the ability to move in and out of these securities without significantly impacting the market prices is of the utmost importance. Evidence of this phenomenon can be seen in other competing ETFs that offer almost identical market or sector exposure. One clear example is the Select Sector SPDRs offered by  State Street (STT). Take, for instance, the  Select Sector Financial SPDR (XLF) and the  Vanguard Financials ETF (VFH): Despite sporting nearly perfect correlations and sector exposure, the SPDR's average daily trading volume is more than 450 times that of the Vanguard ETF. Also, the SPDR's assets under management are 20 times that of the Vanguard ETF, even though Vanguard charges a lower expense ratio. A similar case would be the  S&P 500 SPDR (SPY) compared with the  iShares S&P 500 ETF (IVV), where the decisive advantage goes to the first mover.

One final factor to consider before delving into these aggressive products is tax efficiency. In order to meet their objective of amplified daily returns on their respective benchmarks, these ETFs enter into swaps and other derivative contracts. These contracts are "marked to market" every day and the ETFs are taxed on a "look-through" basis (meaning the investor is taxed as if he or she had owned the underlying securities that the ETF invested in). Therefore, investors owning these products can expect to be hit with short-term capital gains tax rates when they decide to sell--regardless of how long the investment was held.

The bottom line is that these aggressively leveraged products are not particularly attractive as long-term investments. However, we do concede that there are sophisticated investors out there who will appreciate the financial flexibility afforded by the leverage these types of ETFs provide. We simply suggest that these extremely volatile securities be kept on a tight leash.

Given the rough October that many investors had, the temptation to double or even triple down using some of these products will be great. But just like any Gamblers Anonymous member will tell you, the only time a casino doesn't make money is when people stop gambling there--not because people won too much money. The individual investor should keep in mind that in the end, expected returns should always be measured against expected risks. For the average Jane and Joe, these funds have a very limited, if any, place in a portfolio.

 

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