The Riskiest ETFs on Earth – 3X Sector ETF Short/Long

The 3X Index ETFs from Direxion have been all the rage since they launched and picked up traction on the heels of the Proshares 2X Index ETFs of yesteryear, going Long or Short various indices as outlined below. For the uninitiated, you can now get triple the return of say, an energy ETF or emerging markets ETF in a given day (note: I bolded “day”). These Triple Return ETFs have been both a blessing and a curse for retail investors, depending on whether they timed their bet right (referring to a leveraged inverse sector ETF as an “investment” is a stretch) on both a directional basis and on a velocity basis. Why, you might ask, would it matter when you bought into a particular ETF Short as long as the underlying index eventually moved downward during your investment horizon? That’s the rub. As many articles as I see on the virtues of these turbo charged instruments, I see twice the number of comments and questions on message boards from investors asking how the heck a triple short ETF can lose money when the underlying sector index declined over a given time period. The answer is Daily Balancing. Take a look at the real-life example below.

3X ETF Short Loses Money in a Down Market!
As a proxy, consider the XLF Financials ETF. Now, the applicable 3X sector ETFs are FAS (3X long) and FAZ (3X inverse). We all know what happened to Financials last year, but in recent months, Financials have actually rallied somewhat, since the Depression era scenario that our politicians painted for us in order to justify massive bailouts did not occur. During 2009 YTD period (almost 6 months as of the time of this writing), XLF is down only 6%. Now, if you bought FAZ with the intent of tripling the inverse return of the Financial sector loss of 6%, you’d think you’re looking at ~18% return over the same period right? Well, OK, there’s an expense ratio, so you’d be happy with say, 16%, right? Well, take a look at this chart of how FAS and FAZ performed vs. XLF and tell me if you’d be upset looking for a payday of 16% on FAZ:




Summary:

1X Underlying Index ETF -(-6% Return)


3X Long ETF -(-64% Return)


3X Short ETF – (-84% Return)

They All Lost Money! How Could This Be?

This is because of daily rebalancing. It’s virtually a mathematical certainty that if you don’t catch a massive, sustained trend on the underlying index, due to the daily volatility component, you’re going to lose money over long periods by holding the 3X ETF Short or Long, no matter what the underlying index is doing.

Here’s another alarming example. Going back to the Financials, since the 3X ETFs didn’t exist throughout all of 2008, but the 2X Proshares did, which employ a similar approach, with XLF losing 60% from Jan2008 to present (May2009), you’d think you could have made a killing on the 2X ETF Short Financials SKF, right? Wrong! You actually lost 55% in the 2X Inverse ETF XLF at the same time the underlying index was hammered. And of course, if you were 2X Long with UYG, you lost 91%. All 3 lost money again.




Huh?


With Triple Long and Triple Short equivalents for the underlying Emerging Markets ETFs, Energy ETFs, Financials ETFs, etc. all have wild volatility, you could end up losing your shirt if you bet the wrong way. And if you want to give yourself an extra jolt with options, they’re quite expensive as well due to the implied volatility (yes, the Triple ETFs do offer derivatives as well. It’s like strapping a nuclear warhead to a conventional incendiary bomb). I’ve modeled some of this myself and in conjunction with looking at historical charts, over long periods, it seems to be a net loser game unless you cherry pick discreet perfect time periods to have bought and sold.

Short ETF Pairs Trading Strategy
Since leveraged ETFs tend to decline in value over time due to daily rebalancing, I’ve shared the results of my dual-pair inverse Short ETF Strategy. The results are astounding. In any market, I’ve both backtested and personally achieved double digit gains with no direct correlation to the underlying index.

All 3X Leveraged ETF Short and Long Options from Direxion
Below is a listing of all the 3X ETFs currently offered by Direxion (visit this comprehensive list of all leveraged ETFs including the 2x sector funds from Proshares):

Triple Long ETFs Index Tracked Index Ticker

BGU Daily Large Cap Bull 3x Shares Russell 1000 300% RIY
MWJ Daily Mid Cap Bull 3x Shares Russell Midcap Index 300% RMC
TNA Daily Small Cap Bull 3x Shares Russell 2000 300% RTY
ERX Daily Energy Bull 3x Shares Russell 1000 Energy 300% RGUSEL
FAS Daily Financial Bull 3x Shares Russell 1000 Financial Services 300% RGUSFL
TYH Daily Technology Bull 3X Shares Russell 1000 Technology Index 300% RGUSTL
DZK Daily Developed Markets Bull 3X Shares MSCI EAFE Index 300% MXEA
EDC Daily Emerging Markets Bull 3X Shares MSCI Emerging Markets Index 300% MXEF
TYD Daily 10-Year Treasury Bull 3x Shares NYSE Arca Current 10-Year U.S. Treasury Index 300% AXTEN
TMF Daily 30-Year Treasury Bull 3x Shares NYSE Arca Current 30-Year U.S. Treasury Index 300% AXTHR



Short





BGZ Daily Large Cap Bear 3x Shares Russell 1000 -300% RIY
MWN Daily Mid Cap Bear 3x Shares Russell Midcap Index -300% RMC
TZA Daily Small Cap Bear 3x Shares Russell 2000 -300% RTY
ERY Daily Energy Bear 3x Shares Russell 1000 Energy -300% RGUSEL
FAZ Daily Financial Bear 3x Shares Russell 1000 Financial Services -300% RGUSFL
TYP Daily Technology Bear 3X Shares Russell 1000 Technology Index -300% RGUSTL
DPK Daily Developed Markets Bear 3X Shares MSCI EAFE Index -300% MXEA
EDZ Daily Emerging Markets Bear 3x Shares MSCI Emerging Markets Index -300% MXEF
TYO Daily 10-Year Treasury Bear 3x Shares NYSE Arca Current 10-Year U.S. Treasury Index -300% AXTEN
TMV Daily 30-Year Treasury Bear 3x Shares NYSE Arca Current 30-Year U.S. Treasury Index -300% AXTHR