Good Evening …and thank you to Fidelity for inviting us and hosting here tonight. What a great event and a great turnout. I know I for one I have already learned quite a bit this evening. Tonight I will be discussing Levered ETF’s, particularly Direxion Shares ETF’s Levered ETF’s have been in the news quite a bit recently….I know I personally have read many articles So tonight I hope to touch on a number of the topics being discussed, and hopefully shed some light into how these ETF’s work.
These are trading tools. Before trading them, understand: how they use leverage Compounding - how daily objectives and leverage affect daily returns and risk; and longer term returns and risk We’ll also give you some insight into when and how traders use them.
Leveraged ETFs seek to keep a constant leverage ratio on a daily basis, which can vary up and down between 2:1 or 2x (to double the return) and 3:1 or 3x (to triple the return). With leveraged inverse ETFs, the funds seek to return the inverse of their stated leverage ratio (between -3x and -1x), also on a daily basis. To obtain the necessary exposure, the funds will invest in some combination of equity baskets and derivatives—typically swaps or futures contracts . These derivatives are agreements that provide the ability to gain exposure to specific indexes and sectors without the need for full dollar-for-dollar investment. The Bull ETFs generate a portion of their requisite exposure from equities and the remainder from derivatives. The Bear ETFs generate their entire short exposure through derivatives. The actual holdings in the leveraged and leveraged inverse ETFs are quite different than the holdings of non-leveraged ETFs that typically hold a basket of securities. The following tables provide perspective on the typical holdings within various types of leveraged and leveraged inverse ETFs
1. Initial Allocation and Exposure: If a 3x ETF has $100 million in net assets, $300 million of net exposure to the fund’s underlying index must be maintained. 2. Index Rises 1% If the index increases by 1% in a trading day, the gross exposure would rise to $303 million and net assets would rise to $103 million, resulting in a $3 million gain. 3. ETF Exposure Adjusted Since gross exposure must always equal 300% of net assets ($103 million in net assets x 300% = $309 million) at the beginning of each trading day, $6 million of exposure must be added to the portfolio.
Let’s examine what happens in the same 3x Bull Fund when the underlying benchmark index declines. When the underlying index declines, the assets of the fund also decline, so the fund must reduce its exposure to the index so that the fund’s total exposure is once again equal to 300% of the fund’s new level of net assets. 1. Initial Allocation and Exposure: If a 3x ETF has $100 million in net assets, $300 million of net exposure to the fund’s underlying index must be maintained. 2. Index Declines 1% If the index decreases by 1% in a trading day, the gross exposure would decline to $297 million and net assets would decline to $97 million, resulting in a $3 million loss. 3. ETF Exposure Adjusted Since 300% of $97 million equals $291 in exposure, the current exposure must be reduced by $6 million from $297 million to $291million.
In a steadily rising market, the fund’s gains may be larger than expected. In this first example, the ETF gained 89.85%, more than the 75% gain expected, given the 25% index gain and the fund’s exposure level of 300%.
In a steadily declining market, the fund’s loss may be less than expected. In this next example, the ETF declined 60%, less than the 75% loss expected, taking into consideration the 25% index loss and the fund’s exposure level of 300%.
In volatile markets, the pursuit of daily investment targets will have a negative impact on the ETF's performance for periods longer than a single day, as illustrated in this final example. When the market is flat in terms of overall performance over a period of time, the daily fluctuations in the index are volatile. A leveraged ETF can actually generate negative returns for the period. In this last example, the index is flat for the six-day period (the index value is 100 initially and while volatile, ends at 100), but the fund lost 4.50% despite achieving its daily target.
Leveraged ETFs seek daily goals, which means that the returns of the ETFs over time should not be expected to be a multiple of the cumulative return off the benchmark for the longer period. This piece illustrates how different volatility levels of a fund’s benchmark index can impact the returns of leveraged ETFs for periods greater than a day. For the period from May 28, 2010 to September 30, 2010; the Philadelphia Semiconductor Index (SOX), the benchmark for the Direxion Daily Semiconductor 3X Bull (SOXL) and Bear (SOXS) funds, experienced higher volatility, which affected the funds’ returns. Volatility in these graphic examples is a statistical measure of the dispersion of returns for the above market index. Generally, the higher the volatility, the riskier the security and the higher risk to investment. Although the benchmark index lost -1.28 over the holding period, the Bull Fund returned -13.84%, much more than 3x the benchmark’s negative return. The Bear Fund lost -16.15%, much more than -3x the benchmark’s negative return.
During the period from October 1 , 2010 through January 31, 2011; the same index experienced much less volatility than in the previous example. The benchmark index gained 26.50% over the holding period. The Bull Fund gained 93.68%. That’s 17.18 percentage points MORE than 3x of the benchmark’s return. The Bear Fund lost 54.63%, which is 24.87 percentage points better than -3x of the benchmark’s return. Warning! As nice as it is to see greater than expected returns, you must understand that these compounded returns will increase (for a bull fund) your exposure levels beyond your original 3x level, making your position more sensitive to future market movements. Consider selling your excess gains and managing to a specific exposure level.
Leverage can allow an investor to maintain additional exposure to a position with the same or reduced amount of capital. A partial leveraging strategy is used to increase exposure to an underlying investment through the use of a leveraged investment. Hedging is the strategy of purchasing an inversely related investment to reduce the risk of adverse price movements. A hedge can help protect gains and reduce volatility in a declining or volatile market. This has been used more and more frequently with leveraged inverse fixed income ETFs as investors look to hedge gains on long only fixed income portfolios or take a position to benefit from a rising interest rate environment. The Portable alpha strategy to add diversification to a portfolio while maintaining equivalent exposure to the original allocation. By employing leverage to free up capital, proceeds are typically invested into alpha generating, non-correlating assets.
Usually, there’s a stable relationship between mining stocks and gold. Sometimes, and just recently, there’s a divergence between the two. A recent sell-off in gold-mining stocks leaves the gold mining index at a relatively steep discount to gold (measured by the spread, or difference, between the values of spot gold and the gold miners index). In the past, that gap has been closed relatively quickly as gold has fallen or mining stocks have rallied. Recently, that divergence has narrowed.
An effective tool for hedging. This example points out a scenario in which one of our Treasury Bear funds is used to hedge a long FI portfolio against a potentially negative Fed decision. The use of leverage allows you to get more short side exposure with less capital. since you do not need a margin account to short and create hedge positions, you cannot loose more than your initial investment.
The first quarter was highlighted by worries of inflation in Eurrope. Then, as the sovereign debt crisis continues to spread with Greece, and possibly the rest of the PIIGS recently added to the mix, investors, including large institutional players took positions on how this would affect Developed and Emerging Market Stocks. Volumes surged in Developed Market and Emerging Market Bear leveraged inverse ETFs…
There are few myths surrounding Leveraged ETFs….the 2 most common I hear are They exacerbate market volatility …particularly at the close. That the inverse or bear funds exacerbate market declines. We reject both of these notions …we have done a lot of analysis around these two topics and we have not seen any evidence that really supports these accusations.
As I mentioned earlier …we rebalance at or towards the close …so We are absolutely market participants towards the close …..but it is also very easy to determine what it is we need to do at the close and we believe that the rebalance trades are being arbitraged like any other rebalance event …like a Russell rebalance etc …..this has helped and will continue to help mute any of the effects of the rebalance trade. Arbitrage is the simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time. An Authorized Participant is an entity chosen by an exchange-traded fund's (ETF) sponsor to undertake the responsibility of obtaining the underlying assets needed to create an ETF. Authorized participants are typically large institutional organizations, such as market makers or specialists The authorized participant plays a critical role in the construction of an ETF's creation unit (large blocks of the ETF's underlying shares of equity or other assets). After acquiring all the underlying stocks that will form the ETF, the authorized participant will often need to transfer the shares to a custodian bank. New ETF shares are created in the primary market in large lots called creation units by financial professional called Authorized Participants. Once these shares are created, they become available for purchase to all investors in the secondary Market. Source investopedia.com
This slide just points out that the volatility at the opening is historically much greater then it is at the close ….and we are not market participants. we are not in the market or trading at this time…
The myths of leveraged etfs: Leveraged ETFs are creating net short positions in financials Bear funds create large short exposures But the truth is: Leveraged ETFs were net long financials through the most volatile markets Short exposure positions of bear ETFs represent only a small fraction of overall short exposure
If you intend to hold leveraged ETFs for periods greater than a day, you must always watch them closely. During highly volatile periods for a fund’s benchmark index, you will need to adjust your positions frequently to maintain constant exposure levels. During periods of lower volatility for the benchmark index, you should continue to monitor, but position adjustments will likely be needed less frequently. If you don’t have the resources, time or inclination to constantly monitor and manage your positions, leveraged ETFs are not for you. The Funds are not suitable for all investors and should be utilized only by sophisticated investors who understand leverage risk, the consequence of seeking daily leveraged investment results and intend to actively monitor and managed their investments.
ETFs apalancados by Direxion
Rules of Engagement forLeveraged ETFsSpeaker: Sylvia Jablonski SVP, Product Strategy DirexionShares For internal use only
Important DisclosureDirexion is not affiliated with or employed by Charles Schwab & Co. Inc, and theirpresentation should not be construed as a recommendation or endorsement by Schwab. Youmust decide about the appropriateness of their products and services for you. Schwab doesnot supervise third-party firms and takes no responsibility to monitor the products or servicesthey provide to you.The views expressed are for general information purposes only and are not intended toprovide specific financial, accounting or legal advice. Schwab makes no representation aboutthe accuracy of the information or its appropriateness for any given situation.The information and opinions contained in this presentation have been obtained fromsources believed to be reliable, but no representation or warranty, express or implied, ismade that such information is accurate or complete and it should not be relied upon as such.This presentation does not purport to make any recommendation or provide investmentadvice to the effect that any inverse or leveraged ETF is appropriate for all investmentobjectives, financial situations or particular needs. Prior to making any investment decisions,investors should seek advice from their advisers on whether any part of this presentation isappropriate to their specific circumstances. This presentation is not, and should not beconstrued as, an offer or solicitation to buy or sell any products. Expressions of opinion arethose of Direxion only and are subject to change without notice. 2 For internal use only
Important Disclosure, cont. An investor should consider the investment objectives, risks, charges, and expenses ofDirexion Shares carefully before investing. The prospectus and summary prospectus containsthis and other information about Direxion Shares. To obtain a prospectus or summaryprospectus, please visit www.direxionshares.com. The prospectus should be read carefullybefore investing.There is no guarantee of success with any technique, strategy or investment.The VIX (ticker symbol for the Chicago Board Options Exchange Volatility Index) is an indexdesigned to track market volatility as an independent entity. The S&P 500 Index is a broad-based unmanaged measurement of changes in stock market conditions based on 500 widelyheld common stocks. One cannot invest in an index.The views in this presentation are intended to assist the audience in understanding the Funds’investment methodology and do not constitute investment advice, nor is it a recommendation tobuy or sell securities. 3 For internal use only
What we’re covering today> Daily Investment Objectives – Tactical Trading Tools> Leverage – How It Affects Risk and Return> Compounding – When Does It Matter?> How Can They Be Appropriately Used?> Myths> Risks: Counterparty> The Bottom Line 4 For internal use only
Who uses Inverse and Leveraged ETFs?Inverse and Leveraged ETFs are designed for sophisticated investors who:> Understand the risks associated with the use of leverage> Understand the consequences of seeking daily leveraged investment results> Intend to actively monitor and manage their investmentsThese funds are not suited for conservative investors who:> Cannot tolerate substantial losses in short periods of time> Are unfamiliar with the unique nature and performance characteristics of funds that seek leveraged daily investment results> Are long term investors who do not monitor their portfolios frequentlyThe risks associated with the funds are detailed in the prospectuses and summary prospectus, which include: adverse market condition risk, adviser’s investmentstrategy risk, aggressive investment techniques risk, concentration risk, counterparty risk, credit and lower-quality debt securities risk, equity securities risk, currencyexchange risk, daily correlation risk, daily rebalancing and market volatility risk, depository receipt risk, foreign and emerging markets securities risk, sector securities risk,interest rate risk, inverse correlation risk, leverage risk, market risk, non-diversification risk, shorting risk, small and mid cap company risk, tracking error risk, and specialrisks of exchange-traded funds, market timing activity and high portfolio turnover risk, investing in other investment companies and ETFs risk, commodities securities risk,geographic concentration risk, valuation time risk, derivatives risk, commodity-linked derivatives risk, wholly-owned subsidiary risk, tax risk, options and futures contractsrisks, security selection risk, Debt Instrument Risk, Gain Limitation Risk, Leverage U.S. Government Securities Risk, and Special Risks of Exchange-Traded Funds.ETFs are bought and sold directly by shareholders in a primary market and trade throughout the day on an exchange. ETFs are bought and sold at market price (notNAV) and are not individually redeemed from the fund. Brokerage commissions will reduce the returns. Market price returns are based upon the midpoint of the bid/askspread at 4:00 pm Eastern time (when the NAV is normally determined) and also do not represent the returns you would receive if you traded shares at other times.Investing the funds may be more volatile than investing in broadly diversified funds. The use of leverage by a fund means the Funds are riskier than alternatives which donot use leverage. Aggressive investing would include the use of futures, enhanced betas, and shorting securities. Shorting securities occurs when investors sell securitiesthey don’t own and are committed to repurchasing eventually. Alpha is a measure of performance on a a risk-adjusted basis. The excess return of the fund relative to thereturn of the benchmark index is a fund’s alpha. Futures are financial contracts obligating the buyer to purchase an asset such as a physical commodity or a financialinstrument, at a predetermined future date and price. Swaps are the exchange of one type of asset, cash flow, investment, liability or payment for another. 5Distributor: Foreside Fund Services, LLC For internal use only
Leverage: The Basics> Leveraged ETFs are a combination of equity baskets and derivatives – typically swaps or futures contracts.> This allows investors to gain exposure to specific indexes and sectors without the need for full dollar-for-dollar investment. Typical Composition of a 2x ETF Strategy Equities Derivatives Bull Funds 80%-100% 100%- 120% Bear Funds (inverse) 0% 200% Typical Composition of a 3x ETF Strategy Equities Derivatives Bull Funds 80%-100% 200%- 220% Bear Funds (inverse) 0% 300% 6 For internal use only
Daily Investment Objectives:3x Bull Fund when the underlying index risesWhen the underlying index rises, fund assets rise. The fund must increase its exposure to theindex so the total is once again equal to 300% of the fund’s new level of net assets.Hypothetical ExampleIndex Rises 1%(in millions)* These performance numbers do not reflect daily operating expenses and financing charges, are hypothetical in nature, and are not representative of actual Direxion Shares returns. There is no guarantee the funds will achieve their objective. 7 For internal use only
Leverage: Risk and Return3x Bull Fund when underlying index risesThe incremental return of the investment in this scenario would be $1,500, which is 3x the daily increase in theindex (15%) multiplied by the amount of the total initial investment. These performance numbers do not reflect daily operating expenses and financing charges, are hypothetical in nature, and are not representative of actual Direxion Shares returns. There is no guarantee the funds will achieve their objective. For internal use only
Daily Investment Objectives:3x Bull Fund when the underlying index declinesWhen the underlying index declines, fund assets decline. The fund must reduce its exposure tothe index so the total is once again equal to 300% of the fund’s new level of net assets.Hypothetical ExampleIndex Falls 1%(in millions)* These performance numbers do not reflect daily operating expenses and financing charges, are hypothetical in nature, and are not representative of actual Direxion Shares returns. There is no guarantee the funds will achieve their objective. 9 For internal use only
Leverage: Risk and Return3x Bull Fund when underlying index declinesThe loss on the investment in this scenario would be $1,500 which is 3x the daily decrease in the index (-15%)multiplied by the amount of the total initial investment. These performance numbers do not reflect daily operating expenses and financing charges, are hypothetical in nature, and are not representative of actual Direxion Shares returns. There is no guarantee the funds will achieve their objective. For internal use only
The Risks of CompoundingExample: Market Rises SteadilyThe fund’s gains may be larger than expected.*These numbers do not reflect daily operating expenses and financing charges, are hypothetical in nature, and are not representative of any specific fund’s returns. There is no guarantee the funds will achieve their objective. 11 For internal use only
The Risks of CompoundingExample: Market Declines SteadilyThe fund’s loss may be less than expected.*These numbers do not reflect daily operating expenses and financing charges, are hypothetical in nature, and are not representative of any specific fund’s returns. There is no guarantee the funds will achieve their objective. 12 For internal use only
The Risks of CompoundingExample: Market is Flat, Yet VolatileIn volatile markets, the pursuit of daily investment targets will have a negative impact on theETFs performance for periods longer than a single day.*These numbers do not reflect daily operating expenses and financing charges, are hypothetical in nature, and are not representative of any specific fund’s returns. There is no guarantee the funds will achieve their objective. 13 For internal use only
Compounding: Volatility MattersMore is not always betterHypothetical Index experiences higher volatility. 3.84% -19.99% Volatility Hypothetical Index Hypothetical 3x ETF Time / Trading Days Hypothetical 3x ETF Hypothetical Index Hypothetical 3x ETF Hypothetical 3x ETFInformation presented here is hypothetical and meant for illustrative purposes only. For internal use only
Compounding: Volatility Matters Less is sometimes more The same index experience much less volatility than in the previous example.100% 120.0% Index Return = 28.50%90% 100.0% 3x Index Return = 85.50%80% 80.0% Bull Fund Return = 91.68%70% 60.0% Difference = 6.18%60% 40.0% -3x Index Return = -85.50%50% 20.0% Bear Fund Return = -56.63%40% 0.0% Difference = 28.87%30% -20.0% Volatility20% -40.0% Hypothetical Index10% -60.0% Average Volatility: 20% Hypothetical 3x ETF 0% -80.0% Hypothetical 3x ETF Day 1 Day 2 Day 3 Day 4 Day 5 Day 6 Day 7 Day 8 Day 9 Warning! Greater than expected returns are nice, but compounded returns increase (for a bull fund) your exposure levels beyond 3x, making your position more sensitive to future market movements. 15 Information presented here is hypothetical and meant for illustrative purposes only. For internal use only
How Are Leveraged & InverseETFs Appropriately Used?Opportunistic Trading> Partial Leveraging> Hedging> Portable Alpha 16 For internal use only
Partial Leveraging: Gold MinersDivergence Between Gold Miners Index vs. Gold Value/Price in Dollars Spread in Dollars % Spread Between Gold Miners and Spot GoldSource: Bloomberg.Past Performance is not indicative of future results. 17 For internal use only
Hedging: Fixed Income Exposure > Short 3x ETFs can provide greater hedging efficiency. > Scenario: There is an FOMC (Federal Open Market Committee) announcement today. You are unsure if there will be a rate cut or hike. A significant portion of your portfolio is allocated to Long Term Fixed Income. Consider the following example: 1. Determine hedge 2. Allocate to a 3x Leveraged 30 Year Treasury ETF $1 invested = $3 of negative exposure 3. After rate decision, choose to leave or remove hedge 18There is no guarantee of success with any technique, strategy or investment. For internal use only
Myths about Leveraged & InverseETFs They Exacerbate Market Volatility, Myth 1: Especially At The Close Bear Funds Exacerbate Market Myth 2: Declines 20 For internal use only
Myth 1: Exacerbating Market VolatilityMyth:> End-of-day trading by Leveraged ETFs impacts volatilityReality:> Leveraged and leveraged inverse ETFs transact at (or near) the close: buying on up days if net long; selling on down days if net long.> Total net long and short exposure trading at end of the day is smaller than the sum of the bear and bull parts.> Market Volatility has been higher at the opening than it has been at the close.Arbitrage is the simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting pricedifferences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; itprovides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time. 21 For internal use only
Volatility at the open is higher than it is at the closeLeveraged ETFs do not rebalance at the openFive minute volatility High Volume NYSE Issues (basis points) 14 0 120 Aug-11 Aug-10 100 Aug-09 Aug-08 Basis Points 80 Aug-07 Aug-06 60 40 20 0% 9:35 10:05 10.35 11:05 11.35 12:05 12.35 13:05 13.35 14:05 14.35 15:05 15.35 16.05Past performance is not indicative of future results. Leveraged ETFs are not market participants in the first half hour of trading, yet volatility is veryoften at its highest level of the day. Therefore there must be other events that are affecting volatility much more than trading by leveraged ETFs. 22Top 100 issues: top 100 trading securities. Basis Point is a unit that is equal to 1/100 of 1%, and is used to denote the change in a financialinstrument (i.e. 1% change = 100 basis points, and 0.01% = 1 basis point). For internal use only
Myth 2: Intensifying Market DeclinesMyth:> Leveraged ETFs are creating net short positions in financials> Bear funds create large short exposuresReality:> Leveraged ETFs were net long financials through the most volatile markets> Short exposure positions of bear ETFs represent only a small fraction of overall short exposure. 23 For internal use only
Risks: Counterparty (CP) ExposureIs Counterparty Exposure a Risk?> YesWhat do you do to mitigate that risk?> Constant credit analysis of counterparties> Diversification of swap exposure to 6 different counterparties> Tri-party Collateral Management: > Segregated Account held at Custodian for benefit of the counterparty > Daily Margin Management > Effectively reduces counterparty exposure to 1 day mark to market risk. 24 For internal use only
The Bottom Line> Monitor and Act When Necessary> Not meant to be held, unmonitored for long periods> Volatile Periods—may need to adjust more frequently> Less Volatile Periods—still need to monitor frequently> Don’t have the resources, time or inclination? Don’t use them. 25 For internal use only