EQIX - DRN Investors Need To Watch For A China Gut-Shot

Summary

• One of the reasons why inflation is so under control is that China has been lying dormant.
• Their impact on global commodity prices is one of the highest, and their reopening efforts could affect headline inflation figures and consumer expectations of inflation.
• DRN is levered 3x to the value of a diversified RE ETF, so lengthened rate cycles could cause a sharp downward revision in price. To be kept in mind.
• Please keep in mind the risks of leveraged ETFs, in particular the effects of this daily reset in leverage. We explain a bit below.

The Direxion Daily Real Estate Bull 3x Shares ETF ( DRN ) is a highly levered exposure to a REIT ETF that tracks its returns daily but multiplies it by 3x. While the Fed's signals that the rate cycle peaking are good for real estate values, we caution investors with the observation that the China reopening could get in the way of a more sustained revaluation. Due to the inherent volatility of DRN, we think investors should keep away for the time being.

Quick DRN Note

As said, DRN tracks a REIT ETF as an index and multiplies its returns by 3x. The underlying index features the following REITs.

Specialised REITs form the majority of the exposures. Some familiar names are Prologis ( PLD ), American Tower ( AMT ), Equinix ( EQIX ) and Crown Castle ( CCI ) as well as some storage REITs. We've covered many of these in the past.

Prologis is a warehouse and logistics real estate REIT. There's good catch-up with the inflation we've seen with rate hiking programmed into the lease agreements. AMT has high quality tenants, is an essential infrastructure and similarly has rate hikes built into the lease agreements. Equinix benefits from sharp demand side economics as it eats the lunch of the internet backbone. Finally, the storage REITs benefit from a consumerist accumulation which is secular.

In other words, the exposures that dominate the target index are some of the RE market's most resilient.

Risks

These leveraged ETFs with reset daily leverage create some risks investors need to be aware about. If the target index of the DRN loses 8%, the DRN will lose 24%. To make back the 24%, a 33% gain would be required. That would require an 11% rebound of the target ETF. Meanwhile, for the target index to get back to square one, it would only have to appreciate the next day again by just a little bit more than 8%. So it's possible for the index to make net gains and the DRN to make net losses even though the DRN is a bull case leveraged ETF. This is called value erosion, and all of these daily reset leveraged ETFs suffer from it. DRN is really for short term trades, it's not designed for longer-term periods. Then there's higher expense ratios than most ETFs, which is another force that erodes your value. Of course, this value erosion kicks in with greater volatility and over longer periods, but that is exactly why you should be careful with DRN in particular which is exposed to speculation on the rate cycle.

As always, you're doing your own due diligence, and intelligent investors and speculators should be sure they understand the dynamics of the instruments they're trading with. Some links for further reading:

The Lowdown on Leveraged and Inverse Exchange-Traded Products

Leveraged and Inverse ETFs: Specialized Products with Extra Risks for Buy-and-Hold Investors

Regulatory Notice 09-31 | FINRA.org

Bottom Line

Quality is not the issue, but when you have a 3x daily leverage and the real estate market is sensitive to the situation with rates, the current market ebullience is a problem.

While we are beginning to lap the worst inflation figures, and while many commodities are deflating which allows for a comprehensive disinflation that the market is unsurprisingly getting excited about, China has been lying dormant. China is a huge buyer of important commodities, including pulp and paper materials, chemicals, oil of course, and things like iron ore and steel. China is mega industrial and the list of commodities that depend on Chinese local demand is very long, and their effect on the price of a typical consumer basket is very meaningful.

The Chinese reopening could start putting some upward pressure on headline figures. Things could get a little dicey for markets, especially for consumer inflation expectations which are not sophisticated and based on distinctions between core and headline inflation, when Chinese demand which this year was nixed starts coming back online with a vengeance after strict lockdowns. If consumer inflation expectations start rising, the Fed will be more committed to a hardline stance and the rate cycle will at best see an extended peak, if not a higher peak.

Of course, the Chinese reopening project may fail as China becomes ostracised further from essential global supply chains like in semiconductors, and the Chinese demographic situation becomes a concern for businesses. Nonetheless, we think DRN investors should take a break considering the 30% run YTD.

For further details see: