The Direxion Daily Financial Bear 3X Shares (FAZ) exchange-traded fund (ETF) tracks 300% of the inverse performance of the Russell 1000 Financial Services Index. As a leveraged ETF, it expectedly comes with a high expense ratio of 0.95%, considerably higher than the average ETF expense ratio of 0.46%. FAZ has depreciated approximately 36% in the past year (as of April 21, 2015), and it would appear as though there is no hope for the trend to reverse. You will often read about how a high expense ratio eats into profits and exacerbates losses. This is true. On the other hand, contrary to popular belief, this doesn't qualify as a no hope investment. (For more, see: Dissecting Leveraged ETF Returns.)
To understand this look at FAZ’s opposite Direxion Daily Financial Bull 3X Shares (FAS), which seeks to mirror 300% of the performance of the Russell 1000 Financial Services Index. Just like FAZ, it comes with a high 0.95% expense ratio. Over the past year, FAS has appreciated approximately 29%. Much more impressive is its long-term performance. On March 2, 2009, FAS traded at $7.33. On April 21, 2015, it was trading in the$122 range. The upside potential for these ETFs is very high, even if you’re holding them long term. (For more, see: Is It a Good Idea to Invest in a Triple Leveraged ETF?)
Why FAZ Over FAS?
You can make the argument that interest rates are likely to increase over the next year, which will favor banks. This is a simple and good point. However, an improved spread won’t have as much weight as actual lending fees. Banks need consumers to take out loans. In order for that to happen, consumers need to feel confident in their future income producing prospects. Unemployment might have improved, but underemployment is a concern. In other words, with the exception of high-skill service jobs, most people are accepting jobs for less money than they earned in the past. Due to increased health care costs and reduced demand for products and services, many companies are laying off workers. If you combine underemployment and layoffs, then lending is likely to decline not increase.
Another problem is massive debt burdens found throughout numerous industries, which was fueled by prolonged low interest rates. When rates go up, debt will become more expensive. The companies owning this debt must then find a way to cut costs, which will lead to yet further layoffs. Once again, the end result will be less lending. One example is in the energy sector.
Low Oil Prices Add Pressure
With oil prices plunging, banks who lent money to energy-related companies are not in a good position. Oil prices are now too low for these companies to be able to service their debts. Therefore, defaults are likely. We’re still in the early stages of this trend, so the average retail investor likely won’t be aware of it. But some other investors might be. For instance, John Paulson’s Paulson & Co. recently sold 14 million shares of JPMorgan Chase & Co. (JPM). George Soros recently sold over one million shares total in JPM, Citigroup, Inc. (C) and The Goldman Sachs Group, Inc. (GS). It should also be noted that Morgan Stanley (MS) has been unable to sell the debt on $850 million in loans made to Vine Oil and Gas. (For more, see: The World's 10 Most Famous Traders of All Time.)
Percentage of investment banking revenue in oil and gas:
Bank of America Corp. (BAC): 7.4%
Goldman Sachs: 7.1%
JPMorgan Chase: 6.6%
The Bottom Line
The energy-related pressure is a concern, but it's not the key culprit. That would belong to a lack of wage growth and the likelihood of a deflationary environment in the near future. If this proves to be accurate, then there will be more saving and deleveraging not an increase in loans. This would be a net negative for banks. Am I correct? That remains to be seen. (For more, see: Top Inverse ETFs for 2015.)
Dan Moskowitz does not own shares in JPM, C, GS, MS or BAC. He is currently long on FAZ, TECS, DRR, TWM and BIS.