XBI - LABU: 2 Requirements For Making Money In This Leveraged Biotech Fund

2023-05-30 10:00:00 ET

Summary

• LABU is a 3X leveraged fund that has disappointed the biotech bulls.
• The sector looks beaten and perhaps cheap relative to long-term prospects.
• LABU can work for medium term returns if two requirements are met.

The vast black hole that swallowed up tons of capital in 2022 was particularly harsh to 3X funds. The leverage plus the volatility meant that the suffering would be taken to a whole new level. Direxion Daily S&P Biotech Bull 3x Shares ETF ( LABU ) was one of those and delivered an abject performance.

That slide did not stop in 2022 and the fund is down another 6% in 2023. We look at what this fund does and how you should use it to speculate.

The Fund

Like all leveraged 3X funds we follow, LABU aims for single day tracking of the index returns and magnifying that. LABU follows the S&P Biotechnology Select Industry Index and aims to add some juice to that already volatile sector.

These leveraged ETFs seek a return that is 300% of the return of their benchmark index for a single day. The funds should not be expected to provide three times or negative three times the return of the benchmark’s cumulative return for periods greater than a day.

Source: Direxion LABU website

For this level of leverage, the fees are pretty decent.

The longer term returns, though, are not.

Of course, that goes to underscore that these are trading vehicles and you cannot put them into a "buy and hold" portfolio. The risks are just too high and too many investors find this out after they have lost huge sums of money. That 96% looks even more devastating when you benchmark against SPDR S&P Biotech ETF ( XBI ) which had a small positive return over the last 8 years.

Outlook

Biotechnology firms are notoriously hard to analyze for generalists. Their success or failure often depends on a single drug or molecule and it is all too common to see the shares of any one of these move 40% down or 300% up in a single day when trial results are announced. That said, generally extremely poor long term returns tend to setup better returns in a sector and vice versa. As we can see using XBI, the sector has delivered awful returns over the last 8 years, trailing S&P 500, healthcare sector and even T-bills by a huge margin.

Fundamentally, big pharma is looking at a giant patent cliff in the next decade and this extends to every player in the sector.

Today, big drug makers are facing an even larger “patent cliff,” with more than $200 billion in annual revenue at risk through 2030. But this time around, many of the brand name drugs losing market exclusivity are biologic products, manufactured from living cells, rather than the chemical pills that previously dominated the ranks of pharma top-sellers.

These biologic drugs, like AbbVie’s ( ABBV ) anti-inflammatory treatment Humira and Merck & Co.’s ( MRK ) top-selling cancer medicine Keytruda, will face competition from so-called biosimilar drugs that, unlike generics, may not be as easily substitutable. Still, it will be a treacherous period for drug makers to navigate, as they will need to replenish their research pipelines and carefully manage new product launches to replace lost revenue.

Source: Bio Pharma Dive

Amgen Inc. ( AMGN ) and Pfizer ( PFE ) both signed multi-billion dollar deals and paid a huge premium to acquire their respective targets. So it not out of the question that collectively, we should see better returns in this sector than what we did in the past.

Playing Through LABU

LABU's fatal flaw comes through its daily magnification of returns. There is no way to turn that daily 300% into a longer term amplification. So for most investors, LABU would be day or at best a weekly trading vehicle. Any longer and decay would eat up your returns. So if you want to wager on Biotech, XBI makes a lot more sense for a buy and hold portfolio. Taking that one step further, if you wanted to leverage those returns, buying LEAP options on XBI would make more sense as you have a better defined outcome with less decay. XBI options are available till December 2025.

With that out of the way, let's say you wanted to play the sector through LABU, how would you do it. The only way here would be to use the volatility to your advantage. The 3X setup creates tons of volatility and that creates huge option premiums. At a minimum, if you are setting up a medium term trade, you have to use the options via covered calls. We will show a couple of examples. The near term September 15, 2023 calls for LABU are shown below.

The $6.00 Covered Calls would return an annualized 80% if the price stayed over $6.00. In other words you are getting very high returns as long as the price does not drop, a lot. Note that the fair value shown in the calculator is not really our "fair value" for LABU. The calculator requires an input there to show a result.

The annualized returns move up even higher on shorter dated options.

We used the $6.50 strikes as an example but even in the money calls offer great returns.

Verdict

LABU remains a day trading tool and one that is a giant vacuum for capital over time. But you can have extended periods of relatively tight movements where the ETF does not go anywhere. Look at the last 1 year for example. LABU is down just 2.34%.

While that still looks bad compared to XBI, we would wager that covered calls on LABU during this period would outperform covered calls on XBI as the premiums are generally insane.

So if you correctly identify such a period before it happens and use covered calls during it, you could potentially make a lot of money.

LABU remains an "avoid" in our books, even though we are generally constructive on XBI. Those speculating in this space for timeframes exceeding a day, should consider the option strategy to counter intrinsic decay of a 3X fund.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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