The Direxion Daily Financial Bull 3x Shares (FAS 0.78%) exchange-traded fund (ETF) is a leveraged fund that aims to triple the daily performance of the S&P Financial Select Sector index. That index includes 73 of the top financial stocks from the S&P 500, including JPMorgan, Berkshire Hathaway, Visa, Mastercard, Bank of America, and Wells Fargo.
FAS uses total swap return agreements with banks to boost its returns. For example, if FAS wants to invest $100 million in the index, it finds a bank to provide it with "synthetic" exposure to $300 million through a short-term loan. The bank then invests $300 million in the index, agrees to pay FAS triple its daily gain, but collects interest from FAS until the swap ends.
Simply put, FAS takes on a lot of leverage in pursuit of its goal to triple the index's gains. But that also means it triples the index's losses on down days. A given swap contract with a bank might last for weeks, months, or years, but its gains or losses aren't cumulative and actually "reset" every day.
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To offset those costs, the fund charges investors a relatively high net expense ratio of 0.89% and parks a lot of its excess cash in U.S. Treasuries. Should investors buy FAS in hopes of tripling the financial sector's returns? Let's review three arguments in favor of buying FAS -- and three reasons to avoid it.
The three reasons to buy FAS
It might be smart to invest in FAS for three reasons. First, if the financial sector performs well, the ETF could generate market-beating gains. President Donald Trump has been pressing the Federal Reserve to lower its benchmark interest rates. If it does, that could strengthen banks by sparking more borrowing activity. Meanwhile, the Federal Reserve's recent proposal to free up $6 trillion in its balance sheet capacity could drive more U.S. banks to ramp up their investments in U.S. Treasuries.
Second, FAS could be used as a hedge against other bearish bets. For example, if you're shorting individual financial stocks or investing in an ETF that bets against the sector, an FAS holding might offset your losses if those stocks rally instead.
Lastly, it does the hard work of bundling multiple messy swaps and other derivatives into a single investment. Buying a single ETF that explains what it is doing in basic terms is much easier for retail investors interested in this sort of investing activity to manage and understand.
The three reasons to avoid FAS
However, FAS has three glaring weaknesses. First, it can't and won't actually triple the Financial Select Sector index's gains over the long term because it resets its gains and losses daily while constantly paying interest on its swap contracts.
Over the past three years, FAS' price rose by 137% as the Financial Select Sector index advanced 60%. More than doubling the index's returns is certainly impressive, but it could quickly give up those gains during a protracted market downturn because the same design that amplifies its gains would similarly triple its losses.
Second, its heavy dependence on swap contracts exposes it to a lot of credit risk. If its counterparty bank fails, it loses its leveraged exposure to the index, and it might still owe interest payments on the original contract. Its liquidity -- both on the investor side and the counterparty side -- could also dry up in another credit crunch or market crash.
Lastly, FAS is highly sensitive to interest rates. If inflation or geopolitical conflicts result in interest rates staying higher for longer than expected, borrowing and lending activity could slow and banks could struggle -- and the ETF would have to pay higher financing costs on its swap contracts.
So, should you invest in this risky ETF?
FAS certainly would not be a good investment for conservative, risk-averse, or passive long-term investors. But if you expect interest rates to decline, the financial sector to heat up, and understand the risks it's taking to "triple" its index's daily gains, then it might be a worthwhile investment -- at least until the next recession.
