SOXS - SOXL And SOXS: Shorting Both Produces An Attractive Pair Trade

2023-08-18 11:15:24 ET

Summary

• The article explores the possibility of pairing Direxion Daily Semiconductor Bull 3X Shares ETF with their Daily Semiconductor Bear 3X Shares ETF to form a pairs trade.
• Forming a low variance couple is appealing because their long-term decay rates significantly outpace their average cost to borrow fees.
• Because the strategy requires one to short both tickers, I currently rate SOXL and SOXS as Sells.

Thesis

While researching the pairing of covered call ETFs with leveraged ETFs, I began noticing that some of my chosen hedges actually net their own significant returns. After deciding to take a look at the possibility of playing two leveraged ETFs against each other, I have found that some of these pairings are quite attractive. This article is looking at the possibility of coupling together Direxion Daily Semiconductor Bull 3X Shares ETF ( SOXL ) with their Daily Semiconductor Bear 3X Shares ETF ( SOXS ). Since this strategy requires one to short both tickers, I currently rate both SOXL and SOXS as Sells.

Fund Backgrounds

Direxion offers both of these triple leveraged ETFs . They are designed to correlate to either 3x or -3x of the daily performance of the PHLX Semiconductor Sector Index. SOXL carries a gross expense ratio of 0.94%, and SOXS carries a 1.02%.

Long-Term Erosion

Leveraged ETFs are designed to move in relation to the daily price action of their underlying. By taking on this goal, they are unable to maintain correlation on longer timeframes, typically resulting in an erosion of Net Asset Value. Enough inexperienced investors have lost money as a result of a misunderstanding of this long-term decay that both the SEC and FINRA have issued warnings. Here, our plan is to short both assets so this decay should work in our favor.

I am going to use iShares Semiconductor ETF ( SOXX ) and Invesco PHLX Semiconductor ETF ( SOXQ ) as references to establish a baseline. Over the last month, SOXX and SOXQ are down by an average of 6.94%, while SOXL and SOXS are down by an average of 2.18%.

When looking at this situation over a full year, SOXX and SOXQ are up by an average of 14.99%, while SOXL and SOXS are down by an average of 35.26%.

I should be clear that by shorting both, one is taking on a coupled position which is expected to produce returns independent of the value of its underlying. The rate of erosion is determined by the number of violent moves the underlying experiences. A higher frequency of violent moves translates to a faster erosion rate and higher returns for the position.

Weighting

When I plug these two short positions into my minimum variance calculator, it is essentially showing the 50/50 distribution I was expecting. If the short SOXS position is $1000.98 for every $1000 that's in the short SOXL position, they will achieve a minimum variance of 0.0201.

Fees

When looking at shorting these two tickers, we also have to consider their annual borrowing fees. For SOXL, the last ten days of trading mostly land below 1%. The average of the ten shown is 0.761%

SOXS has a less attractive rate. Their last ten days of trading have an average of 1.803%.

Projected Returns

Comparing the recent annual rate of decay of the low variance couple to the cost to borrow of its two halves produces a rough estimate for projected returns. With the weighting of each side of the pair being close enough to 50% to consider the difference a rounding error, the math is easier than usual. SOXS currently pays a trailing 3.45% annual yield, SOXL pays a 0.69%, with each of them being half the portfolio, these distributions represent a net drag on returns of 2.07% The effect that their gross expense ratio has on long-term value is already incorporated into their average annual decay rate of 35.26%. The average of their recent borrowing fees is 1.28%. By subtracting both the 1.28% in fees and the 2.07% in distributions from the 35.26% gains from decay, we can produce a rough estimate for annual returns of 31.91%.

Risks

These two assets are designed to be inversely correlated to the same underlying. Although I believe it is incredibly unlikely, it is always possible that one of the two ETFs suffers an unforeseen issue and falls out of correlation with both its underlying and the other half of the pair.

The recent annual decay rate of 35.26% was directly related to the amount of volatility in the PHLX Semiconductor Sector Index over the last year. Regardless of direction, periods with a larger number of violent moves will lead to a faster decay rate. Conversely, anytime the price action of the underlying is more stable, the triple leveraged couple should decay at a slower rate.

Although they are currently quite small, the borrow fees change over time. It is possible that the fees spike and the couple becomes unattractive. The risk here is that this happens while one isn't paying attention and it's allowed to erode value before being noticed.

Conclusions

I have been researching low variance couples for use in a margin portfolio. While most of the low variance couples I have been looking at are pairing a covered call ETF with a leveraged ETF, shorting two inverse leveraged ETFs is also quite attractive. Additionally, I like that the performance of this strategy is uncorrelated to the covered call ETFs I have been researching. When the time comes for me to leave the research phase and test out my low variance portfolio on a small scale, I will absolutely take a fresh look at this SOXL and SOXS pairs trade.

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