Will You Get Slaughtered Betting Against Financials?

The stock market, particularly the financial sector, was feeling the heat during the fall of 2008. Numerous banks, including some of the largest in the country, were on the brink of failure, and the bankruptcy of Lehman Brothers sent a ripple through the American economy, prompting the Department of the Treasury and Federal Reserve to step in with emergency powers created under the Troubled Asset Relief Program.

Out of this doom and gloom rose Direxion Daily Financial Bear 3X Shares (NYSEMKT: FAZ  ) , a leveraged ETF that sought to beat the market by betting against the Russell 1000 Financial Securities index. The thought behind it was that as financial companies continued to get slaughtered in the aftermath of the financial crisis, the fund would return three times the losses for investors. Unfortunately, the financial sector hasn't struggled as much, and the funds performance has been miserable pretty much from the beginning:

FAZ data by YCharts

Inside the index
The Russell 1000 Financial Securities index is made up of a little over 200 companies from various industries in the financial sector. These companies range in size from mega-conglomerate Berkshire Hathaway  (NYSE: BRK-B  ) to small investment brokerage Interactive Brokers Group  (Nasdaq: IBKR  ) . The index itself has performed well enough in comparison to the fund, returning 20.6 percent since the November 2008 launch of the ETF.

Why the failure?
It could just be an example of poor market timing on the part of Direxion, which may not have expected TARP to stabilize the markets by early 2009 and therefore preventing systemic losses in the financial sector. Extended damage to the financial sector, as evidenced by the funds early returns, would have been quite a boon for fund owners. However, this would have only been short-term performance, and that is due primarily to the daily reset of the fund.  

For example, let's look at how a leveraged fund like this suffers when the market goes back and forth between good and bad days. If the index starts out at a value of $100, and loses 10% in the first day, it is now worth $90. Meanwhile, if this fund is doing exactly what it is supposed to do, it would need to increase in value by 30%, which now makes it worth $130. The next day, the index gains 10% back from its new price, so it is now worth $99. Conversely, this fund needs to lose 30% from its current value, a total of $39, so it is worth $91. So while the index lost 1% over two days -- which investors might think should be good for an inverse leveraged fund -- our hypothetical fund here actually lost 9% over that period. Compound this over many days, or four years, like the fund, and it is easy to see why the fund fell so dramatically.

That makes a bit more sense
Now that we have that out of the way, what exactly does it mean? The chart above is a good indicator of how the fund actually works. During short periods of market turmoil, especially in the financial sector, the fund had massive returns. Like late 2008 and early in 2009 while investors and companies were still figuring out the implications of TARP. Early investors in the fund went for quite a roller coaster ride the first four months until being dropped off a cliff in early March. 

FINRA, the group that regulates these sort of things, was prompted by the performance of funds like this to issue a warning to investors , advising them to fully understand leveraged and inverse ETFs, especially as they apply to buy-and-hold investors. While it is all fine and dandy to try and be the inverse of an index on a daily basis, the example I went through above, even over two days, shows exactly how the cumulative effect of the daily reset hampers performance of the fund. I know I don't want to lose 99.5% of my investment, even if it does take four years to do so. 

Answer the question already
The answer to the question posed in the title of this article, at least regarding the Direxion Daily Financial Bear 3X Shares ETF, is a resounding yes, but I still think that it has more to do with the operation of the fund. After all, Direxion Daily Financial Bull 3X Shares (NYSEMKT: FAS  ) , a sister fund that is supposed to benefit from rises in the Russell 1000 Financial Securities index, is down a little over 73% from its start on the same day. And that's a fund that is supposed to be really successful -- 3X as much! -- when the  index performs well. As mentioned previously, the index itself has gained a little over 20%, so you would expect a return closer to 60%, right?.

The problem lies in the daily nature of the fund, making every gain or loss harder to overcome. While great for short-term investors, or hedge funds that invest differently than you or I, it might just be a better idea to find some great financial stocks that you understand. Leave the leveraged ETFs, and their massive losses, to those investors that move in and out of the market.

One of my favorite financial companies is usually not considered a financial company because of its ownership of companies in many different industries. But Berkshire Hathaway, with Warren Buffett at the helm, uses insurance companies to generate the cash necessary to buy all those companies. Buffett won't live forever, though, so investors have to understand the key issues to watch moving forward. To help investors, The Fool's resident Berkshire Hathaway expert Joe Magyer has created this premium research report on the company. Inside you'll receive ongoing updates as key news hits, as well as reasons to both buy and sell the stock. Claim a copy by clicking here now.

Robert Eberhard owns shares of Berkshire Hathaway. Follow him on Twitter, where he sometimes tweets thoughts about investing. You can also follow his CAPS profile, currently sporting a score in the high 80s, by clicking here

The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services recommend Berkshire Hathaway and Interactive Brokers. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (11)

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  • Report this Comment On October 30, 2012, at 10:27 AM, etfspaniel wrote:

    Hi people:

    I expect a crash to happen soon, and when it does it will dwarf the crash of 2008-2009.

    Just before 2009, FAZ was at a peak of around $7K, and around Mar 2009, another peak of around $5K.

    On Oct 26, 2012 FAZ was $17.56. I can buy a call option on FAZ (exp Jan 13/2013) for 0.20 .

    If the crash happens before then, and it is a big one, it would seem to me that I could place a low cost bet and potentially make a lot of money.

    Is there something I'm not getting here ?, can anyone advise what might stand in the way of cashing in ?

    Doug Maenpaa

    etfspaniel

  • Report this Comment On October 30, 2012, at 1:27 PM, TMFKopp wrote:

    @etfspaniel

    I wouldn't doubt that there's some very small probability that there could be another epic financial crash (after all, there's a small probability of many things... including a massive meteor colliding with earth).

    However, as Robert has pointed out above, the very structure of this ETF is flawed for those that want to bet on it as a play over multi-day periods. Because it reflects the "daily" results, some traders may find use for it when trading intraday. But for investors looking over longer time periods, the result you get may not be the one that you'd logically expect.

    I will point out that your strategy in general -- using an instrument to bet on low-probability, high-return events -- is the bread and butter of Nassim Taleb (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a...

    Matt

  • Report this Comment On October 30, 2012, at 3:54 PM, XMFTheGuruEbby wrote:

    To second what Matt said, it is truly hard to predict if or when the next financial crisis will hit, and what effect it will have on the markets. The funds profiled here, however, only appear to be really good in the extreme short-term, perhaps no longer than a week at most in an extended down period.

    For FAZ/FAS specifically, the Russell 1000 Financial Securities index is so broad that even if banks tanked, insurers probably wouldn't be affected in the same way and vice versa. Though our financial industry is very entangled, it is actually less so since the meltdown in 2008 in my opinion, but you never know when someone will invent a new way to cause chaos in the market.

    Thanks for reading!

    Robert

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