It is highly recommended that traders who use these products monitor their positions often to make sure they are maintaining their desired exposure level.
For sophisticated leveraged ETF investors, can you share some strategy plays?
Efficient use of capital (portable alpha)
Using leveraged ETFs in a portable alpha strategy allows a manager to gain equity asset class exposure using a 2x or 3x ETF, essentially letting half or a third of the capital do the work, allowing the balance of capital to be redeployed for other investment and risk-management purposes, such as exposure to yield-enhancing fixed income asset classes.
Inverse ETFs may be used when seeking to hedge the market. As their name reveals, inverse ETFs go up when the market goes down, and they go down when the market goes up. Inverse ETFs allow you to seek the opposite return of specific sectors, asset classes – for instance the S&P 500, Financials, Energy and Tech.
Again, the thing to remember about these funds is that they’ll lose value so long as the market keeps going up. But the potential rewards can be attractive if the market suffers a setback.
At the very least they may serve as a hedge. It’s important to note that a -1x ETF which seeks 100% of the inverse performance of an index, is subject to daily compounding. However, basic math dictates that the compounding would be less than the compounding in a -2x or -3x leveraged ETF.
Used appropriately, even a small allocation of your capital could help make up for any losses you sustain in a market crash.
And of course, individuals should consult a financial professional before engaging in hedging activity.
The daily reset and subsequent compounding affect has led to the emergence of the double-short trade during volatile markets. This is a strategy used by traders who believe that we will experience range bound volatility. Basically, the double short strategy is executed when you construct a portfolio that shorts equal amounts of both the long leveraged ETF and the short leveraged ETF tracking the same index.
Intuitively, you might expect that the two securities would be mirror images of each other and that the sum of the cumulative returns for both securities would be 0%.
But because of the compounding affect caused by the daily reset of the funds’ exposure levels, both the long ETF and the short ETF decrease in value over volatile periods. So going short equal amounts of both results in a positive return. In addition, this trading strategy is exposed to low risk because shorting this pair of securities is market neutral.
Direxion is best known for its 3X leveraged ETF products, but the company is making moves to build out its suite of single inverse (-1X) ETFs. What is this focus all about?
Even before Britain’s vote to leave the EU, investors were grappling with a range of concerns: Slow-to-no economic growth in the U.S. and across the world, unprecedented levels of central bank stimulus overseas, negative interest rates on high-quality foreign government bonds, a painfully slow default by a U.S. territory (Puerto Rico), an extended slowdown in China, increasing terrorist activity, and let’s not forget an election cycle that has at times been downright terrifying. Yet U.S. stocks bumped up against all-time highs again this year hitting a new intraday high of 2,178 on August 1.
As managers feel compelled to prepare strategies for managing pullbacks, they’re also compelled to consider the most efficient and cost effective ways to execute those strategies. Inverse ETFs are easily accessible, liquid trading tools that allow tactically minded managers to hedge market downturns, without the need for a margin account.
Can you discuss the benefits of the products as compared to other hedging strategies?
Direxion inverse and leveraged inverse ETFs from Direxion are funds that seek to provide an inverse multiple (e.g., -1x or -2x or -3x) of the daily return of a benchmark before fees and expenses. Inverse and leveraged inverse ETFs cover a broad range of equity, fixed-income, commodity and currency benchmarks. Many investors consider inverse ETFs to be attractive hedging instruments for the following reasons:
Inverse Correlation: An inverse ETF seeks to achieve the inverse of the one-day performance (or a multiple thereof) of the ETF’s stated benchmark index before fees and expenses. So buying an inverse ETF may provide index returns with the negative correlation, on a daily basis, necessary to implement an effective hedge, without requiring investors to short securities or use derivative-based strategies.
Accessibility: Inverse and leveraged inverse ETFs trade much like stocks on security exchanges and are generally bought and sold in the same way. Unlike derivatives trading, there are no special accounts or other special arrangements are needed.
Intraday Pricing and Liquidity: Since inverse and leveraged inverse ETFs trade much like stocks, they are priced throughout the day to reflect market fluctuations. For some investors, this can make it easier for monitoring and rebalancing.
No margin account needed: Since you are essentially taking a long (owning the asset vs. borrowing an asset to sell short, as explained previously) position in a fund that provides inverse exposure, there’s no margin account needed to purchase an inverse ETF.
No chance of losing more than the initial investment: You can never lose more than your initial investment when using leveraged funds. This is in stark contrast to buying on margin or selling stocks short, a process that can cause investors to lose far more than their initial investment.
Broader diversification as compared to individual stocks: Inverse ETFs may offer a more diversified approach to hedging than shorting an individual stock. Of course if you are acting on the anticipation of news on a specific company, an ETF may not be the right trade. But if you are considering betting against a sector or asset class, inverse ETFs may be a simpler way to execute your strategy.
Able to use in retirement accounts: You can’t short stocks of any type in an IRA. The IRS doen’t allow any form of borrowing in an IRA. You can however, trade inverse ETFs.
For more information about Direxion, visit www.direxioninvestments.com.