The Risks Of Triple-Leveraged ETFs

By Eric Fox | November 10, 2008 AAA

Leverage has become a dirty word in the market. Over-leveraged hedge funds and banks have collapsed under the weight of their bad bets, and investors everywhere have learned to avoid any company that has the leverage taint. It's seems, then, that the timing couldn't be worse for an ETF company to release a new crop of leveraged ETFs, but Direxion pushed ahead with its November offerings eight of triple-leveraged long or short return ETFs.

What's surprising is the funds have turned out to be extremely popular so far. In this article we'll have a look at these funds to decide if the risks are worth the returns. (To learn how leveraged ETFs work, read Dissecting Leveraged ETF Returns and Leveraged Investment Showdown.)

Direxion's Triple Hitters
The eight new funds are:

  • Direxion Small Cap Bull 3x (NYSE:TNA) and Small Cap Bear 3x (NYSE:TZA)
  • Direxion Large Cap Bull 3x (NYSE:BGU) and Large Cap Bear 3x (NYSE:BGZ)
  • Direxion Energy Bull 3x (NYSE:ERX) and Energy Bear 3x (NYSE:ERY)
  • Direxion Financials Bull 3x (NYSE:FAS) and Financials Bear 3x (NYSE:FAZ)

The small-cap funds (TNA, TZA) track triple the return (or the inverse return) for the Russell 2000 Index of small-cap companies. The large cap funds (BGU, BGZ) track triple the return (or inverse return) for the Russell 1000 Index of large-cap companies. The energy (ERX, ERY) and financials (FAS, FAZ) ETFs are also triple-leveraged to the return (or inverse) of the Russell 1000 Energy Index and Russell 1000 Financial Services Index, respectively.

Risky Products
There are some risks to these instruments, and investors should know and understand them before rushing out to buy.

The main risk, of course, is that they are triple-levered, so if the index drops 15% in one year and everything works out the way it should, your bull ETF will drop 42.62%, according to the prospectus. The estimated return is based on the volatility of the underlying index, so it may vary. The prospectus has a chart that shows a wide variety of possible returns. If you own the Bear shares, and the index drops 50% over one year, your return could vary anywhere from 33% to 679%.

This tracking error is influenced by fund expenses, underlying index volatility, differences between securities held in the ETF compared to the index and bid-ask spreads, among other factors. (To read more about the relationship between leverage and volatility, see Price Volatility Vs. Leverage.)

Investors Lining Up
Since these ETFs began trading they have become quite popular with investors. The Large Cap Bull Shares traded more than 5 million shares on Tuesday, Nov. 18, and the Large Cap Bear Shares traded nearly 1.6 million shares. The price volatility on these instruments is astounding. In the past week, the Large Cap Bear Shares have soared from $86 to around $105 and sunk back to $70 before closing at $87.88 on Tuesday, Nov. 18.

The Financial Bull Shares closed over $43 a share on Thursday Nov. 13, and traded as low as $26.20 yesterday.

Bottom Line
The new triple-levered ETFs launched by Direxion last week offer great trading opportunities, but are not for the faint of heart due to the extreme price volatility.

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