FAZ - Fast And Furious Leveraged ETFs (FAS And FAZ)

2023-07-05 08:53:06 ET

Summary

• The article discusses the 2 Direxion Daily Financial Bull & Bear 3x ETFs (FAS and FAZ) and how they provide 3x daily exposure to the S&P Financial Select Sector Index.
• The ETFs are not designed for long-term investment due to high volatility and potential for significant losses, as evidenced by their underperformance in the long term.
• Despite their high risk, the ETFs maintain a good 3x daily leveraged and inverse exposure to the underlying index, making them suitable for tactical or speculative opportunities.

With the recent crisis involving the collapse of several US regional banks driven by rising interest rates, pressure on the financial sector has grown significantly. This article will discuss 2 Direxion Daily Financial Bull & Bear 3x ETF (( FAS ) & ( FAZ )) , where FAS provides 3x daily exposure while FAZ provides -3x daily exposure to the S&P Financial Select Sector Index. It is worth highlighting that 3x daily performance is not at all equivalent to 3x returns over the long-term (even just beyond 1 day horizon) due to the compounding effects. To learn more about the basics of leveraged ETF, you may read more from the Seeking Alpha’s introduction to Leveraged ETF to understand the dynamics better.

In general, the ETFs are concentrated on several large names such as Berkshire Hathaway, JPMorgan Chase, Visa & Mastercard. The index does have quite a diverse split between financial services, banks, capital markets and insurance as well.

Performance Review

Looking at the returns of both indices and its peers ( XLF being the main benchmark here as it tracks the same underlying index as FAS & FAZ but without any leverage), the YTD performance was mainly driven by the U.S. regional banking crisis that took place in March as FAZ massively outperformed all the other funds.

However, it does paint a bleak picture over the long term (Jan 2021 to June 2023), where FAZ significantly underperformed the market while FAS is also in the negative territory. Therefore, both ETFs are actually losers to the overall without any leverage. This emphasizes the point where leveraged ETFs are not designed for long-term investment and underperformance is highly possible due to high volatility that would easily incur huge losses. Any huge loss is then hard to be offset by gains due to diminishing capital base.

Quantitative Risk Analysis

Meanwhile, the annualized volatility for both FAS & FAZ are more than twice as high as XLF, at levels slightly beyond 70%. Plugging these figures into the return-volatility charts that are provided in the prospectuses, the fund is almost guaranteed to provide negative returns or even get completely wiped out over any 1-year period unless significant return is achieved.

“For instance, if the Index’s annualized volatility is 100%, the Fund would be expected to lose 95% of its value, even if the cumulative Index return for the year was 0%.” The charts below is extracted from the Fund’s prospectus.

Using the historical daily volatility and returns, the portfolio returns were also generated through Monte Carlo simulations assuming an investor were to hold either FAS or FAZ for a 3 months period. Based on the histograms below, an investor would very likely lose money by investing in either of the fund, with a very long positive tail where there lies opportunity to generate very high returns (but extremely unlikely). FAS and FAZ do have very similar simulation outcomes but FAZ is more likely to generate negative returns than FAS.

The red lines below indicate 5th & 95th percentiles of the simulated portfolio cumulative returns.

Knowing that the ETFs do not serve as good medium/long-term investment vehicles, they do perform a good job at providing its leverage/inverse exposures. This can be observed as the CAPM rolling beta value for FAS relative to XLF stays very closely to 3 (which means every time XLF moves by 1, FAS moves by 3), while CAPM rolling beta for FAZ is very close to -3 as well.

CAPM rolling alpha values (which indicate the outperformance relative to XLF) of FAS and FAZ also mirror one another, dominated by few significant peaks and troughs. The alpha values for FAS has maintained in the negative territory (and opposite for FAZ) as highlighted in the cumulative return chart at the start, where financial stocks were under stress.

Fundamental Deep Dives

It is also critical to provide an overview on fundamentals into what the ETFs are mainly holding. While the P/E ratio of banks are at conservative levels, other major players in the broader financial services sector such as Visa, Mastercard and S&P Global do have high P/E at beyond 30x, higher than the current P/E ratio for S&P 500 at around 22x.

While high P/E ratios reflect greatly on very high return on equity achieved by Visa and Mastercard, S&P Global does not quite demonstrate that - but rather having a higher than average revenue growth rate. In overall, the top holdings in the ETFs continue to be profitable and will be expected to do so over the medium term with high net interest margin.

On the liquidity front, things may look concerning for Mastercard given its high debt ratio and low short-term liquidity (quick ratio <1). However, it does have a decent interest coverage ratio for long-term debts amid the high interest rate environment.

Conclusion

Similar to other leveraged ETF, FAS and FAZ are not designed to be held for long-term investment due to the extreme levels of volatility and high vulnerability towards downside risk. However, the fund does maintain a good 3x leveraged and inverse exposure with close proximity to the underlying index for any investor seeking for any tactical/ speculative opportunities.

For further details see: