Three years ago, when it first became largely adopted by the mass investing population as a hedge to a collapsing market, the 3x levered ETF known as the Direxion Daily Financial Bear 3X Shares, or FAZ in short, was the hottest thing since sliced bread. Subsequently, it has transitioned form being an object of affection to one of infinite scorn, hatred and outright homicidal urges, for one simple reason: it, like many of its other levered bearish peers, is anything but a way to profit from a collapsing market. In fact, as a recent proxy filing by Direxion indicates, it is virtually impossible to make money in the long-term using FAZ... or medium-term... or, as many would say, even intraday as well. The reason for this is simple: while nobody gets the true inner workings of these inverse x-levered ETFs, certainly not the "experts" who post three times a day on Seeking Alpha, one thing everyone should understand is what the following table straight from Direxion is saying: namely that even if the market collapses by 60%, one could lose up to 96.1% of their entire investment in the FAZ, if for some ungoldy reason, annualized vol surges to 100%. Because, you know, vol only occasionally rises when the S&P plunges by more than half. The same is applicable on any time frame: in essence the FAZ only works if the two massively contradictory Venn diagrams overlap: a market plunge and not rise in vol. Uhm, maybe they should have disclosed that a little bit sooner...
This Direxion explains as follows, just so readers can do a text search in their favorite "short" ETF to confirm that it is nothing but another disguised instrument designed to lose money no matter what the market does:
Over time, the cumulative percentage increase or decrease in the value of the Fund’s portfolio may diverge significantly from the cumulative percentage increase or decrease in the multiple of the return of the Fund’s underlying index due to the compounding effect of losses and gains on the returns of the Fund. It also is expected that the Fund’s use of leverage will cause the Fund to underperform the compounded inverse return of three times its benchmark in a trendless or flat market.
The effect of compounding becomes more pronounced on the Fund’s performance as the Index experiences volatility. The Index’s volatility rate is a statistical measure of the magnitude of fluctuations in the returns of the Index. The table below provides examples of how Index volatility could affect the Fund’s performance. The chart shows estimated Fund returns for a number of combinations of performance and volatility over a one-year period. As shown below, this Fund, or any other 3X Bear Fund, would be expected to lose 31.3% (as shown in Table 1 below) if its Index provided no return over a one year period during which the Index experienced annualized volatility of 25%.
If the Index’s annualized volatility were to rise to 75%, the hypothetical loss for a one year period for the Fund widens to approximately 96.6%. At higher ranges of volatility, there is a chance of a near complete loss of value even if the Index is flat. For instance, if the Index’s annualized volatility is 100%, the Fund would be expected to lose approximately 100% of its value, even if the cumulative Index return for the year was only 0%.
With that table in mind, perhaps the next table is far more palatable: it shows the "performance" of the FAZ-mobile... straight to the poorhouse.
We dread to even calculate what an investment of $100 on January 1 2009 would be worth today.
And here are some other pearls of brilliance from the Direxion proxy:
Shorting Risk — The Fund may engage in short sales designed to earn the Fund a profit from the decline in the price of particular securities, baskets of securities or indices. However, there is a risk that the Fund will experience a loss as a result of engaging in these short sales.
Mmhmm, you go long an inverse leveraged ETF which guarantees to lose you money in the long-run, yet the fund, which works by synthetic and actual shorting, warns you of risk associated with... shorting?
But the kicker undoubtedly is:
Income and capital gain distributions you receive from the Fund are subject to federal income taxes and may also be subject to state and local taxes. Distributions for this Fund may be significantly higher than those of most exchange-traded funds.
Oh, something tells us the likelihood of FAZ being the source of actual taxable income, and thus having to worry a whole lot about this particular risk factor, is not all that high.
In other words: anyone who believes that market may go up or collapse, with vol exploding, should probably consder not going long the FAZ. Or any other levered ETF, all of which effectively guarantee to lose most if not all of your capital. Because apparently America never learned its lesson with synthetic CDOs in the aftermath of Abacus et al.