2024-01-18 13:44:58 ET
Summary
- Levered ETFs like Direxion Daily FTSE China Bull 3X Shares ETF only provide their advertised exposure on very short time horizons due to positive convexity and volatility decay.
- Chinese equities have been performing poorly due to weak economic data.
- However, contrarians might look be tempted to buy Chinese equities due to their cheap valuations.
- Unfortunately, I do not believe the YINN ETF is the best vehicle to play an uncertain Chinese rally, as it may lose significant value before a rally emerges.
In recent months, I have turned bullish on emerging market ("EM") equities due to their cheap valuations. Since China makes up such a large proportion of the emerging market indices, almost by default, I am bullish on Chinese equities. Does that mean one should be bullish on levered exchange-traded funds, or ETFs, like the Direxion Daily FTSE China Bull 3X Shares ETF ( YINN )?
The short answer is no.
Levered ETFs Are Only Suitable For Short-Term Trading
A more nuanced answer is that levered ETFs like YINN only provide their advertised exposure on very short time-horizons. The YINN ETF provides 3x the daily returns of the FTSE China 50 Index (the "Index"), the same index underlying the iShares China Large-Cap ETF ( FXI ).
When investors hold levered ETFs like YINN for longer than 1-day periods, positive convexity and volatility decay can introduce significant tracking error.
For example, in the past year, the YINN ETF has returned -74.4%, which is better (losing less money than expected) than 3x the -29.5% return of the FXI ETF (Figure 1). Positive convexity is the main reason for YINN's less-than-expected losses, as the YINN ETF's exposure got exponentially smaller over time due to persistent losses in the underlying index.
Figure 1 - YINN has large tracking error (Seeking Alpha)
In fact, the past year has been notable for the fact that the FXI ETF has basically declined in a straight line. However, in most years, volatility decay will eat at YINN's returns. The more volatile the underlying index's returns are, the more it will underperform expectations (Figure 2).
Figure 2 - Theoretical performance of YINN vs. underlying index given various volatilities (YINN prospectus)
Investors who want to learn more about the mechanics of the YINN ETF can read my initiation article from November 2022 and these warnings from FINRA and the SEC .
Chinese Equity Sentiment Continues To Be Poor
Unfortunately, my bullishness towards China seems to be misplaced, as a rout in Chinese stocks deepened in recent days, with the Hang Seng China Enterprises Index already down more than 10% YTD in less than 15 trading sessions (Figure 3).
Figure 3 - Chinese stock rout deepens (stockcharts.com)
The main culprit for Chinese equities' poor performance has been weak economic data coming out of China. For example, China recently reported Q4/2023 GDP growth of 5.2% annualized. Although this GDP growth rate was faster than Q3's 4.9%, it was less than the 5.3% that analysts had been expecting.
Similarly, China's retail sales increased by 7.4% YoY in December, missing consensus estimates of 8.0% and slowing from November's 10.1% increase.
Population Decline Accelerates
Perhaps the most important piece of macro news regarding China in recent days is a report that China's population shrank for a second year in a row as a record low birth rate combined with a wave of COVID-19 deaths accelerated a downturn in China's population. According to China's National Bureau of Statistics, China's population dropped by 2.08 million in 2023, or 0.15%, compared to a decline of 850,000 in 2022.
As I wrote in an article more than a year ago on the iShares MSCI India ETF ( INDA ), China's population has likely peaked and will shrink in the coming years (Figure 4).
Figure 4 - Chinese population has likely peaked and will shrink in coming decades (un.org)
The implications for a rapidly aging and shrinking Chinese population is far-reaching. First, China will likely cease to be the world's factory in the coming years, as its working age population shrinks and companies move production elsewhere due to geopolitical concerns. This will lead to structural inflation globally.
More importantly, China's population is aging before the nation becomes wealthy. Given China's weak social safety net, many elderly Chinese will not have adequate access to healthcare or pensions. A declining population will also exacerbate China's housing issues, as there will be less demand for new homes. Finally, older populations are generally more risk averse and deflationary.
Unlike the rest of the world, which is battling inflation , China is currently at the precipice of deflation (Figure 5).
Figure 5 - China is battling deflation (tradingeconomics.com)
But Valuations Argue For A Cyclical Bounce
While the long-term prospects may look bleak for China and Chinese equities (and thus pose a headwind for YINN), investors should not get too discouraged. Stocks often reflect future prospects, and when current economic conditions look worst may actually be the best buying opportunity.
According to a recent Bloomberg article , the current spread between the earnings yield on Chinese equities compared to bonds of 5.7% is approaching levels that have historically led to spectacular forward returns (Figure 6).
Figure 6 - Chinese equities are historically cheap (Bloomberg)
Historically, there have been 5 instances over 2 decades of this stock-bond yield gap reaching 5.5% or more. In each of these instances, Chinese stocks rose in the following 12 months, with an average return of 57%.
Volatility Decay Makes Me Hesitant On YINN
However, unless Chinese equities suddenly turn around their performance and rally in a straight line in the coming days and weeks, I would recommend contrarian investors stay away from the YINN ETF, due to the "volatility decay" mentioned at the beginning of this article.
For example, if we invested $100 in YINN and the FTSE China 50 Index returns 5% on day 1 ($100 x [1+[3 x 5%]] = $115), followed by -5% on day 2, investors are left with only $97.75 ($115 x [1 + [3 x -5%]] = $97.75), significantly less than three times the 2-day compounded loss of 0.25% or $99.25.
Since the timing of a potential Chinese equity rally is highly uncertain and will likely involve lots of back and forth, I fear volatility will eat away a lot of any potential gains.
Instead, I prefer to hold well-managed, unlevered funds like the Templeton Dragon Fund ( TDF ) to play any eventual rally in Chinese equities.
Conclusion
Given the poor performance of Chinese equities, investors may be tempted to play for a contrarian bounce using the Direxion Daily FTSE China Bull 3x Shares ETF. However, I strongly advise against this action.
The YINN ETF is a levered ETF that suffers from volatility decay if held for long periods of time. Since the timing and path of any potential Chinese equity rally is highly uncertain, investors may suffer large levered losses in the meantime. For contrarian investors, I think it may be safer to place bets using unlevered funds like the Templeton Dragon Fund or passive ETFs to play for a mean reversion in Chinese equities.
For further details see:
YINN: Even Contrarians Should Avoid This Trap