Leveraged ETFs: Is Volatility Your Best Friend or Worst Enemy?

The following post was written and/or published as a collaboration between Benzinga’s in-house sponsored content team and a financial partner of Benzinga.

Volatility can play the part of an unsung hero or a dastardly villain in the story of returns when it comes to Leveraged ETFs. This piece explores 2 examples that illustrate why such disparity might be the case and what a trader or investor can do to be aware.

High Volatility Just Might Be Your Enemy

The chart below displays the daily returns for 2 Leveraged ETFs and their underlying benchmark index beginning in mid-June until the end of July 2021. During this period, the Russell 1000® Financial Services Index (RGUSFLA), the benchmark for the Direxion Daily Financial Bull FAS and Bear FAZ 3X Shares, experienced a high amount of volatility. This volatility, of course, affected the returns of the ETFs as well.

Source: Bloomberg. The performance data quoted represents past performance. Past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate. An investor’s shares, when redeemed, may be worth more or less than their original cost; current performance may be lower or higher than the performance quoted. For the most recent month-end performance click here.

During the above period, the percentage gain or loss for the 2 ETFs and benchmark were as follows:

• -1.36% Russell 1000® Financial Services Index (benchmark)  
• -6.25% Direxion Daily Financial Bull (FAS) 
• 0.33% Direxion Daily Financial Bear (FAZ)

What is surprising in this data set is that FAS, the bull ETF, clocked in more than 3 times the loss than the benchmark did for the period; similarly FAZ, the bear ETF, recorded less than 3 times the inverse of the benchmark for the period. 

This phenomenon, called volatility decay, is one of the reasons that leveraged ETFs are meant for short-term trading rather than long-term holding periods. Volatility decay is especially pronounced when a market experiences high volatility but trades mostly flat for a period of time.

Low Volatility Might Be Your Friend

During the period from the end of January to late February 2021, the same index traded slightly higher with much less volatility than the previous example.

The percentage gain or loss for the 2 Leveraged ETFs and benchmark for this period were as follows:

• 11.24% Russell 1000® Financial Services Index (benchmark)  
• 36.18% Direxion Daily Financial Bull (FAS) 
• -28.72% Direxion Daily Financial Bear (FAZ) 

 

Past performance does not guarantee future results.

Nevertheless, you can see the bull ETF, FAS, had a return that exceeded 3 times that of the underlying index by more than 3%.  The reason for this outperformance is that both the FAS and FAZ ETFs are rebalanced daily, leading to a compounding effect on returns in an upward trending market that is experiencing low volatility. 

Bottom Line

These leveraged ETFs seek a return that is +300% or -300% of the return of their benchmark index for a single day. The funds should not be expected to provide 3 times or negative 3 times the return of the benchmark’s cumulative return for periods greater than 1 day.

In pursuit of their daily investment objectives, leveraged ETFs must rebalance their assets-to-exposure ratio on a daily basis. This means that their returns over time are the product of a series of daily returns, and not the ETF’s beta multiplied by the cumulative return of the index for periods greater than a day.

Consequently, those looking to trade these ETFs should be aware of both the overall trend of the market during their selected time horizon and the overall volatility for the period, since both factors combined will affect returns of the ETF.  These leveraged funds should be monitored daily and adjusted when necessary to ensure that neither compounding nor volatility decay wreaks havoc in one’s portfolio.

An investor should carefully consider a Fund’s investment objective, risks, charges, and expenses before investing. A Fund’s prospectus and summary prospectus contain this and other information about the Direxion Shares. To obtain a Fund’s prospectus and summary prospectus call 866-301-9214 or visit our website at www.direxion.com. A Fund’s prospectus and summary prospectus should be read carefully before investing.

Investing in a Direxion Shares ETF may be more volatile than investing in broadly diversified funds. The use of leverage by a Fund increases the risk to the Fund. The Direxion Shares ETFs are not suitable for all investors and should be utilized only by sophisticated investors who understand leverage risk, consequences of seeking daily leveraged, or daily inverse leveraged, investment results and intend to actively monitor and manage their investment.

The Russell 1000® Index is a trademark of Frank Russell Company (“Russell”) and has been licensed for use by the Trust. The Direxion Daily Financial Bull and Bear 3X Shares are not sponsored, endorsed, sold or promoted by Russell. Russell makes no representation regarding the advisability of investing in the Direxion Daily Financial Bull and Bear 3X Shares.

Direxion Shares Risks – An investment in each Fund involves risk, including the possible loss of principal. Each Fund is non-diversified and includes risks associated with the Funds’ concentrating their investments in a particular industry, sector, or geographic region which can result in increased volatility.

The use of derivatives such as futures contracts and swaps are subject to market risks that may cause their price to fluctuate over time. Risks of each Fund include Effects of Compounding and Market Volatility Risk, Leverage Risk, Market Risk, Market Disruption Risk, Aggressive Investment Techniques

Risk, Counterparty Risk, Intra-Day Investment Risk, and risks specific to the securities of the Financial Sector. Performance of companies in the financials sector may be materially impacted by many factors, including but not limited to, government regulations, economic conditions, credit rating downgrades, changes in interest rates and decreased liquidity in credit markets. Additional risks include, for the Direxion Daily Financial Bull 3X Shares, Daily Index Correlation/Tracking Risk and Other Investment Companies (including ETFs) Risk, and for the Direxion Daily Financial Bear 3X Shares, Daily Inverse Index Correlation/Tracking Risk, and risks related to Shorting and Cash Transactions. Please see the summary and full prospectuses for a more complete description of these and other risks of each Fund.

Distributor: Foreside Fund Services, LLC.

The preceding post was written and/or published as a collaboration between Benzinga’s in-house sponsored content team and a financial partner of Benzinga. Although the piece is not and should not be construed as editorial content, the sponsored content team works to ensure that any and all information contained within is true and accurate to the best of their knowledge and research. This content is for informational purposes only and not intended to be investing advice.