TMV - SPXS Is In Positive Drift Now But SDS Is A Safer Hedging Instrument

2023-12-01 16:38:24 ET

Summary

• Direxion Daily S&P 500® Bear 3X Shares ETF is a popular instrument for hedging a stock portfolio and shorting the market.
• Like all leveraged exchange-traded funds, the SPXS ETF is subject to volatility drift, explained hereafter.
• The drift is positive now, but the historical average is negative while historical drift is close to neutral for ProShares UltraShort S&P500 ETF.

Direxion Daily S&P 500® Bear 3X Shares ETF ( SPXS ) is one of the most popular instruments to short the broad market for trading or hedging purposes. However, its daily -3X leverage factor is a source of drift. It must be closely monitored to detect changes in the drift regime. This article explains what "drift" means, quantifies it in more than 20 leveraged exchange-traded funds ("ETFs"), shows historical data, and finally concludes about the current market conditions. The analysis is also valid for the ProShares UltraPro Short S&P500 ETF ( SPXU ), which tracks the same index with the same factor and has an almost identical behavior.

The reason why leveraged ETFs drift

Leveraged ETFs often underperform their underlying index leveraged by the same factor. The decay has essentially four reasons: beta-slippage, roll yield, tracking errors, management costs. Beta-slippage is the main reason in equity leveraged ETFs. To understand what is beta-slippage, imagine a very volatile asset that goes up 25% one day and down 20% the day after. A perfect 2x leveraged ETF goes up 50% the first day and down 40% the second day. On the close of the second day, the underlying asset is back to its initial price:

(1 + 0.25) x (1 - 0.2) = 1

In the same time, the perfect leveraged ETF has lost 10%:

(1 + 0.5) x (1 - 0.4) = 0.9

It is not a scam, just the normal behavior of a leveraged and rebalanced portfolio. A good news: in a trending market, beta-slippage can be positive. If the underlying index goes up 10% two days in a row, on the second day, it is up 21%:

(1 + 0.1) * (1 + 0.1) = 1.21

The perfect 2x leveraged ETFs is up 44%:

(1 + 0.2) * (1 + 0.2) = 1.44

Beta-slippage is path-dependent. If the underlying index gains 50% on day 1 and loses 33.33% on day 2, it is back to its initial value, like in the first example. However, the 2x ETF loses one third of its value, instead of 10% in the first case:

(1 + 1) x (1 - 0.6667) = 0.6667

Without a demonstration, it shows that the higher the volatility, the higher the decay.

Monthly and yearly drift watchlist

There is no standard or universal definition of leveraged ETF drift. Mine is simple and based on the difference between the leveraged ETF performance and Ñ times the performance of the underlying index on a given time interval, if Ñ is the leveraging factor. Most of the time, this factor defines a daily objective relative to an underlying index. However, some dividend-oriented leveraged products have been defined with a monthly objective, mostly defunct exchange-traded notes ("ETNs") sponsored by Credit Suisse and UBS: CEFL, BDCL, SDYL, MLPQ, MORL…

First, let’s start by defining “Return”: it is the return of a leveraged ETF in a given time interval, including dividends. “IndexReturn” is the return of a non-leveraged ETF on the same underlying asset in the same time interval, including dividends. “Abs” is the absolute value operator. My “Drift” is the drift of a leveraged ETF normalized to the underlying index exposure in a time interval. It is calculated as follows:

Drift = (Return - (IndexReturn x Ñ))/ Abs(Ñ)

“Decay” means negative drift. “Month” stands for 21 trading days, “year” for 252 trading days.

The best and worst drifts

• The leveraged bull ETFs in real estate ( TNA ) and gold ( UGL ) have the largest, but moderate, monthly decays of this list: -0.43% and -0.41%, respectively.
• The leveraged bear biotechnology ETF ( LABD ) shows the worst 12-month decay: -10.66%.
• The leveraged bear semiconductors ETF ( SOXS ) has the highest positive drift in one month: 3.55%.
• The leveraged bear Nasdaq 100 ETF ( SQQQ ) shows the highest 12-month positive drift : 17.80%, in a large loss.
• SPXS has a positive drift in both time frames: 1.62% in one month, 5.97% in 12 months.

Positive drift follows a steady trend in the underlying asset, whatever the trend direction and the ETF direction. It means positive drift may come with a gain or a loss for the ETF. Negative drift comes when daily returns skip between positive and negative values (“whipsaw”).

Focus on SPXS history

Since inception on 11/5/2008, SPXS has lost 99.99% of its value, through many reverse splits. However, hedging with SPXS has worked quite well in many cases. For example, in the first week of the 2020 market meltdown (2/21 to 2/28/2020), it has gained about 40%, significantly more than SPY's return (-11%) multiplied by the leveraging ratio (-3). Then, I have issued a warning on 3/10/2020 against leveraged equity ETFs. A few weeks later, SPY had lost 17.5% and SPXS gained about 16% in the same time: less than by shorting SPY without leverage. Then, the monthly drift has oscillated between positive and negative values, and the 12-month drift was negative until February 2021. It became positive again and spiked in April 2021. Last year's bear market put it back in negative territory in April 2022. It is slightly positive now.

The next chart plots the 12-month drift since January 2000, using real prices from November 2008, and synthetic prices based on the underlying index before that. The historical average is negative: -3.03%.

Direxion Daily S&P 500® Bear 3X Shares ETF is an efficient hedging instrument against sharp corrections in a bull market. Moreover, the cost of hedging is quite cheap compared with other derivatives. However, it suffers a large decay when the S&P 500 has alternatively positive and negative days. The VIX index (implied volatility) may be a warning, but it is not mathematically related to decay. In volatile times, ProShares UltraShort S&P500 ETF ( SDS ) incurs a lesser risk of decay, as plotted on the next chart. The historical average is close to zero (-0.09%).

Additionally, shorting an asset or buying an inverse ETF implies an additional decay due to inflation and magnified by the leveraging factor.

In conclusion, leveraged ETFs are designed for seasoned traders understanding the implications of leveraging and the inflation bias. Most investors should stay away from them.

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