Animal Spirits Podcast - Talk Your Book: Positive and Negative Compounding: Trading Direxion Leveraged ETFs

Episode Date: March 16, 2020

On today's show we speak with Dave Mazza, head of product at Direxion about trading levered ETFs, and other products they're working on. Find complete shownotes on our blogs... Ben Carlson’s A Wealth of Common Sense Michael Batnick’s The Irrelevant Investor Like us on Facebook And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation. Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is brought to you by direction. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Battenick and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holt's Wealth Management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritt Holt's wealth management. This podcast is for informational purposes only and should not be. relied upon for investment decisions. Clients of Ritthold's wealth management may maintain positions

in the securities discussed in this podcast. So we sat down with Dave Maza to talk about direction, to talk about their products, their future. And this is definitely one of the more interesting fun families out there. Would you agree? Yeah, I thought this was probably one of the bigger myth-busting podcasts that we've had. Because I think after talking to Dave, I'm I changed my mind in a lot of the ways that I look at these products, I think. Well, I think especially because whenever you read about their products, it is always in a negative light. And I understand why. And listen, I was steamrolled. I'll admit, I lost some money trading these things. What was your triple inverse bearish financials or something?

So I started trading these things in 2010, and I was buying the triple levered bare financials. The only problem is the bear market already ended and nobody told me. You're a little late. But Dave was very upfront and honest about the way that these should be used and how they're tactical funds. And he talked about how volatility can whipsaw you in these things. And they're not meant to be buying hold. And it sounds like most investors have hopefully figured this out. But my point in the talk with him was it's kind of wild that investors,

even have the ability to express themselves tactical in this way, how hard this would have been to do 10 or 15 years ago if you wanted to do something like this? And I think the biggest surprise to me was I would have assumed it was all hedge funds trading these things. And he said, no, no, no, it's like 60 to 70 percent retail, right? Yeah. It is a lot of individuals that are trading these. But he was very upfront with how they should be used and some of the other things they're getting into. And this, I think this talk with him changed my mind about how I look at these things in a lot of ways. So have you traded these since we spoke to Dave?

No, that doesn't mean I'm going to turn into a tactical investor just because the option is available. And hopefully people who have tried this have learned their lesson. But the other thing was, so I had a friend a couple years ago who said, hey, I'm going to be working for another 30 or 40 years. I'm dollar cost averaging into the SNP 500. Why wouldn't I just dollar cost average into the direction three times? long S&P 500. And we talked to Dave a little bit about this on the show, but his

point was, yes, that could work out where you dollar cost average in and you get the three times. But the big thing that matters in this case, if you're going to get actually get that three times over the long term, because these things are reset daily, is what is the volatility? Because if it's a really volatile environment, even if stocks are up, that could whipsaw you and hurt you. And so you may not get exactly that three times because we looked at the returns for the three times levered S&P over the last 10 years. This thing has been around for 10 years. It's up 35% per year.

So it has worked. And his point was this has been the perfect environment for it because there hasn't been that much volatility. But in the December 2018, bare market, I'll call it. I think the market was down just about 20% and this thing was down almost 50. Right. And so in a 2008 scenario,

it would probably be down 90% maybe, 95. It's so the, I mean, you just have to have nerves of steel for something like that. But he was very quick to point out that, again, these things are for tactical holding. And they're making some more thematic ETFs that are going to be still leveraged, but maybe more for buy and hold and maybe longer term trades. But this was a good myth busting. And I'm guessing a lot of people don't know. the reasoning behind a lot of this stuff.

What you just mentioned, that, that I was pretty excited about. So direction has made some products to express themes. So if you favor value over growth or growth over value or cyclicals over defensive or international versus domestic, whatever it is, instead of, I don't know, doing pair trades or constructing it yourself, this is like just a one-stop shop for that. So I'm excited to see how that takes off what the reception is going to be if that's going to gather any assets. I think that has potential. So here's our conversation with Dave Mazza from Direction. We are sitting here with Dave Mazza, head of product for Direction. Dave,

thanks for coming in. Thanks for having me. So Direction has been around for about a decade at this point, and they are primarily known for leveraged ETFs. Is that correct? Yes. What are leveraged ETFs? How do they work? Leverage ETFs are a unique part of the ETF ecosystem. We're effectively on a daily basis, we are guaranteeing that you have a multiple of return for an underlying index. So think about the S&P 500. Our product SPXL is intended to provide three times the daily return of the S&P 500. On the other hand, XPXS is trying to do the opposite, which is the three times the inverse of that return on a daily basis. So using that as a jumping off point. I had a friend recently actually come to me and said, hey, I know you're in the investment

business. I kind of understand the markets. I have 30 to 40 years ahead of me of dollar cost averaging. I've been using the SMP 500. What is to stop me from using SPXL in dollar cost averaging into this if I understand the volatility characteristics? So maybe you could use that as a jumping off point in terms of the best and worst case uses of these products. Here's what's interesting about leveraged and inverse ETS, especially leverage ETFs on the long side, is if you were to go back and look over the past 10 years in the ETF market, some of these products are going to be the best performing, they're also going to be the worst performing because I can't protect that volatility path. Now, if I could, I would recommend to your

friends that that would make sense, but I know I can't and likely she can't and likely nobody can. So that's why these are really intended for tactical traders who are going to own them and look at them on a daily basis. Right. Just looking at the performance, it was up 100% last year and changed, and the year before it was down 25%. So there's just this, the range of outcomes is huge. But maybe you could talk through how the volatility works in terms of resetting these products as well. Ben, do you mind if I jump in here?

Thank you. So we went back five years, because I remember when we spoke about this, your friend said this. So over the last five years, this product, the triple levered S&P 500 product, is up 240% compared to the S&P 500 of the same time, up 70%. So roughly three times the amount. However, to the point of like, can we stick with it, in 2018, when stocks fell about 20%, this fell about 50%. Yeah. So yeah, you're getting all the upside, but you're getting more than all the downside. Well, as we know, volatility hurts worse on the downside. And really it becomes of what does that return path look like? So what's interesting in the market, as you guys know, the market we've been in has been remarkable because volatility has been so low. In fact, abnormally low. And in that particular time frame, you benefit from compounding because every day when we re-lever or de-lever the fund based off of what that performance has been on that day, investors have

benefited in some cases. In other cases, when you see returns that have been extremely choppy and extremely volatile, you will end up with worse performance, which is why it's very rare to find someone who actually ends up, if they have intended to own these, seeing that outcome with what their expectation is because again, the goal is to deliver this on a daily basis. So sometimes, I'm sure there's been investors all over the place that have used these products and not really understood what they were, that they bought it and held and there was negative compound. And they're like, well, wait a minute. The underlying is down 10%. How come I'm down 35%. So how is it

that it tracks fairly to what it's supposed to be on a daily basis, but then over time it diverges. How does that happen? Well, it really depends on what that underlying volatility environment has been. So if you have kind of a smooth trend lined, especially up, you'll benefit from positive compounding. But if you have an environment where markets are down big one day, up big another, down big another, down big another, down a little bit another, that's when you're going to see negative compounding come into play. And again, one can't really predict that, which must certainty. So you are kind of at the whims of what the market environment has done. In fact, we're talking about the S&P 500 here, but if you look at products which have inherently more volatility like

semiconductors or gold miners, that's actually where we see some of the worst benefits of negative compounding. But again, in theory, if we ended up in an environment where gold miners, which they haven't been, kind of end up in a trending market environment, you'd see something similar to what you saw with the S&P 500. But it's good to compare something like what we have seen with technology stocks or S&P to something which hasn't done as well, simply. from a one beta perspective. So you can understand the range of outcomes for these with the optionality that's introduced with leverage can be quite wide. So who are the investors and who should be the investors that use these? Really, we recommend that these products are used by what we call

tactical traders. And what does tactical traders mean? It could mean something different for you than different for me. But really, it's intended for someone who's going to pay attention to their portfolio on a very frequent basis. Most of the clients that we speak to that engage with these products, they're not putting all of their money in them. They likely have their money with an advisor or in a long-term strategy. And part of this is used in their alpha-generating bucket or in an area that they want to pay attention to and they want to be engaged with the markets because there is some opportunities for some great gains. But if you're not paying attention, there's opportunities for significant loss. I think in his trading days, Michael had some experience

with FAS or FAS? Well, I was the bear, as I'm so inclined. Three times bears financial. That's FAS. Yeah. It was like 2010. And I was like, hey, wait a minute. I thought we're in a We're in a recession. What's going on? The double dip never came. Didn't work out well. So to that point, getting back like the three times stuff, all right. So I've always said that volatility can be a tax on returns, especially in the downside.

So you tend to see the biggest volatility both up and down in a bad market. So you'll see a down 5% day and then it bounces 4% the next day. So if you are positioned for in the bearish product, you could sort of be punished because you get like the negative compounding, even if you're on the right side of the trade. And so that's why, especially if a trader or anyone is looking at using the bear products in any way, shape, or form, that's when you need to, I'd say, pay even more attention to what you're normally fine because of that, because you are really positioned against where naturally markets go, which, as we know, over intermediate and especially longer term horizons is higher. Yeah, that's like really swimming against the waves. I would like to get into some of the more nitty gritty here because it's kind of wild to me that investors have access to something like this when in the past, this would have been just hedge funds, basically. Now investors can do this, and this is a good or a bad thing, depending on how you use it,

obviously. But how is it work behind the scenes when you actually, especially in the bearish products and you're shorting these, how do you actually implement these strategies? You touch on something interesting. I think these particular types of ETS, especially if you look at some of the press that they got, when they were first launched, right around the financial crisis, really, which is right around when ETSs in general were becoming a larger part of the financial markets here in the U.S. and as we know now globally, people were maybe using them incorrectly or not,

or even more so not understanding exactly the pros and cons that can come with this. So with that being the case, it is important to really understand how they're actually built and especially how they're built on the short and long side because they're different. In nearly every case, the products are structured by having some of the, a bull portfolio, having some exposure to the underlying securities, so whether that's S&P 500 stocks, or maybe an ETF that offers exposure to SMP 500 stocks, and then a total return swap or a series of total return swaps that can help deliver that multiple on a daily basis.

And there we are used large financial services companies as our counterparties, but they're delivering that particular exposure. Now, on the bare side, it's mostly total return swap because it's really, it needs to provide us with the inverse of that particular exposure. How exactly is that done inside of an ETF? Again, what's interesting about ETFs, and now we know non-transparent ETFs are coming, and that's a conversation for another day. But it is 100% transparent to someone who is going to buy the product or own the product. You will see on any given day, whether you look at our website or your preferred financial site, you'd see the holdings.

In the case of the S&B 500, again, it would be all 505 stocks or an ETF, and then plus line items for any cash that we need for collateral, or in addition, the swaps that we have with our various counterparties. So people have referred to products like these as weapons of mass financial destruction. Is there any risk of an XIV type event? Has anything like that happened with one of your products? Not at all. So one thing which is important to remember, and I don't want to say that that could never be the case.

But everything that direction has offered historically and in the future is not a derivative of a derivative. And that's really where the challenge came with those volatility-based products is the VIX is a construct. The VIX doesn't exist. The S&P 500 is an index, right? So it's representing a basket of actual securities that can be owned on an individual basis.

They're not representative of options contracts that's trying to track a particular outcome of a volatility series. So in addition, we also have, deep in the prospectus, but it's there, and we encourage people to read these documents for a reason, some of the provisions that we have in place should worst-case scenarios occur

so that the funds would not go down to zero and be closed like that particular product. So to be clear, there are risks with these particular products that could happen in worst case scenarios, but we have provisions in place at the fund level, at the management level to try to help mitigate should those situations occur. Are there any products that you see a lot of interest in or a lot of liquidity in that maybe investors don't pay attention to very often, where you see technical traders and investors using quite a bit that would kind of surprise people? Well, I think what's interesting is when I think about our ecosystem of leverage and inverse

ETFs, is there's oftentimes a lot of interest in these as hedging tools. And we often think about these as purely speculation tools. And they can be that way, right, for someone, again, who's trading and trying to make the most of their gains on any given day. But there is a utility to use these as hedges. Now, they are hedges like any other type of hedge, requires you to have some. precision, but we don't just offer 3x inverse. We have one X inverse. And that's a product that has some interest, but we do see from time to time more episodically large investors coming in and

using that for a few day period to help hedge out some of the risks that they could see coming in the market, where they can get with a smaller capital outlay, get some greater exposure than which they could with maybe more expensive tools that are available in the market. So just to be clear, are any of these products designed to be bought and held, or are they really all trading vehicles? Well, at Direction, we have been making strides to offer additional tools that can be more buy and hold. But when we're talking about our leverage and inverse suite, really especially the 2x and primarily the 3x products, those are really intended to be used as trading tools. So what is on the horizon for direction? So I joined direction a little over a year ago

as the head of product. Most of my career was at larger financial services firms, really focused on what most would consider more traditional ETF offerings. And so, about a year ago last year, we really kind of made our first positioning in that regard and offered a series of 150-50 ETFs. These are really interesting. I'm obviously biased, but I think they're cool tools where more portfolio construction can be used with that particular structure. And so what I mean by that is we simply take, in the case of RWGV, the Russell 1000 growth index at 150% exposure, balanced with minus 50% exposure to the Russell 1,000 value index. So, for an investor who's traditionally made decisions, maybe over a six or 12-month period, that growth

is going to outperform value, this can give you amplified exposure to that, but without the challenges that can come with a daily leveraged three-times product. And you have the opposite of that as well? Exactly. And we have the opposite of that. So we have RWVG, which does just the opposite, 150% exposure to value stocks, short 50% exposure to growth stocks. Yikes. The list here is great. for your relative weight ETFs you call them. So cyclicals over defensives or defensives over cyclical. So you could do almost like a risk on, risk off, U.S. versus international, developed versus emerging. I think these themes are really, really interesting ideas. We're pretty excited about having these products in the lineup and really available to investors. Because to your point is,

if I look at performance and you said, yikes, RWGV was up 40% over the last year. And it did exceptionally. It did exactly what it's expected to do. Now RWVG, underperforming, value because you were short growth. But that's the whole point. In the case of our relative weight suite, we offer both sides of the implementation. So for someone who wants to make that overweight to growth, they can do so or make that overweight to value, they can do so. My favorite products, not to say I have a favorite child, is actually the cyclical defenses and defensive cyclicals. In the case of the ETF market, sector investing has been around for a long time, but there's actually not offerings that just package them together just in

that cyclicals or just in that defensive basket. And so while these are done, in a 150-50 structure, they're really actually the first ETFs that just give you that combined exposure to your more risk-on sectors or your more risk-off sectors. What's in the underlying? What exactly goes on there? In those particular cases, the long side is implemented with 100% exposure to individual equities. And then we do use total return swaps to get that additional 50-50. But in this case, they're balanced. So the challenges with negative compounding come into the fact when you have growth and net exposure over 100. In this particular case, for $100 of investment, you get $200 of exposure, but it's 100 plus 50-50. So it's balanced relative to another. And really the idea

here is you can capture the fact that you might be right on the long side and you get that spread between the long and the short side. Obviously, before ETFs existed, it would have been impossible to implement these because you need the daily trading and liquidity access. Anything about the ETF structure that has made it easier for you to guys to implement some of these strategies? The ETF structure in many cases, especially with the relative weight, makes it a lot easier to implement because, again, we can tap into the expertise that we have with accessing the short side and using derivatives to deliver that particular outcome. There also is some benefits that really exist with ETFs when it comes to tax efficiency because of the way that we are

implementing the particular strategies. I was going to ask getting to the tax stuff, how do dividends work? in these products? So in the case of the leverage and inverse products, they're intended to be total return vehicles. And the swap is done as such. So you shouldn't expect you may be receiving dividends and income really from the cash collateral side and things of that nature. What's interesting with relative weight is you still have that 100% long exposure to value or to defensive stocks in the case of RWDC. So you will receive dividends from those. And then the swap side is really just for that 50-50. I'm going to go out on. on a limb and say people aren't looking for dividend income and three times levered

ETFs. Just a hunch. I guess my question was like, what should investors expect to receive from the dividends? Well, yeah. So more so in the case of relative weight, you would expect to receive an income stream, which is consistent to what that underlying exposure is. So any new products coming besides the relative weight ETFs? I think of our relative ETFs is really the tip of the spear of what the investment community can and should think about direction. So we're known as the 3X guys. We're known as the folks who provide amplified exposures for traders. The 150-50 products take that heritage, but begin to bring it to the buy and hold community. The future for us is really, we're not running away from leverage. We're not

running away from our great client base that we have there, but we want to be relevant to additional investors, a wider range of folks who might not be interested in tactical trading. So we are looking to continue to offer solutions that are different than what we had in the past. One in particular that comes to mind is an ETF that we have the direction flight to safety strategy ETF. And this is an ETF which is intended to give exposure for investors who want to hedge against equity-centric portfolios. And what do we mean by flight to safety? It combines physical gold, large-cap utilities, and long-term treasuries in a basket together, which in and of themselves have uncorrelated exposures and can be used as an easy to understand diversity.

a fire in a portfolio. Interesting. And do you expect that to be used by tactical traders as well? Well, it certainly could be, right? So someone could say, market is going to enter a risk off period, thinking about putting on a hedge for a short period of time. But I really more view that strategy is something which I would just almost set it and forget it, right? It's a way to participate in the markets, but also provide some protection. You know, many alternative strategies, as you guys know, are costly. They're complicated. This is neither. It's intended to be a low-cost offering using the ETF structure, very easy to understand what the exposures are. Is there leverage? There's no leverage. It's a long, only type strategy. We actually

reweight those three underlying exposures based off of their inverse volatility. So the least volatile asset will have the greatest weight in that portfolio based off of its, again, that five-year history. And then we do so rebalancing that on a quarterly basis. How does the physical gold work with that? There we're going to use an ETF. So that's a case where we're not going to go out and try to do something better than some of the gold ETF's offering. We'll leverage the benefits of gold and the ETF structure alongside individual treasuries and utility stocks. So in addition, we're taking that 150-50 structure and applying it to two other places. One, which I'm really excited about, is ESG. So we know ESG sometimes gets a great rap, sometimes gets a bad rap, depending upon your

particular perspective on whoever's making ESG or SRI news. But this ETF is really the first of its kind. And many ETF say that, right? You guys have heard it a million times. It's my first ETF that does that does this. But in the case of ESG, there's not many strategies that directly short companies that have poor ESG scores and then go long companies that have good ESG scores. So ESNG does just that. So based off of using an MSCI methodology that focuses on companies with positive ESG ratings and positive trend in those ratings, we'll own the 100 stocks on the long side that have that best of breed within their sector. And then we're going to be short those stocks with the worst and who are getting worse in that particular regard.

So why I like this is that this will tell you, and I can't guarantee it's going to outperform, but this will tell you if ESG works. So on a three and six months, 12 months basis, as we build up the track record, and this is going to have proof in the pudding. What's the ticker? ESNG. Okay. I love this because we're starting to hear, I heard this at lunch recently from a product person, that ESG is an alpha strategy.

And okay, well, we'll see. Maybe it is, maybe it isn't. But this is like, this will put that feet to the fire. Correct. So again, to get back to the 150-50 idea, so basically you get 200% gross, 100% net. Yes. You're technically net long because you're long 150 and short 50. That's correct.

Exactly. Yeah. So you get greater. capital efficiency with this particular structure. To get into the weeds a little bit, the other thing we're doing here is we're looking at it within their sector. So I'm rewarding companies that are better relative to their peers. Because if I were to do this without sector caps, I'd run into all the biases that people say about some ESG strategies, where I'm going to be own just tech stocks and consumer discretionary on the long side. I'm going to be short oil

and gas. I want to reward oil and gas companies that are doing better than their peers and then actually go short companies in the tech sector or any sector that traditionally is known as a good ESG sector that's doing poorly and maybe even getting worse. So will the rebalancing on that be quarterly? Yes, that's correct. And then one other strategy, which is for us, the first in the factor space, is another 150-50 strategy, but different than relative weight, where we take the S&P 500 long, the 100 stocks in the S&P 500 with the highest quality, and then 50% short that with the lowest quality. So again, this is, we know quality as a factor. It's a bit more nebulous compared to something like value or size, but it's growing in popularity. It's seen a lot of interest. If I look at

2019 ETF flows, but this is another area where we can get proof in the pudding is a particular company that has better return on equity, lower accruals, lower leverage. Is it outperforming those that are not? And that can be bought in held. Exactly. And it's structured to be a way that can be bought in held. So it's all about greater capital efficiency in the case of 2MJ and the case of ESNJ. And for us, we're pretty excited about these particular 15050s, our ETF focused on flight to safety, which the ticker there is flight. How's that spelled?

FLYT. Okay. In addition, I want people to begin to think of direction as more than just a 3X provider. These begin to make us forays into that regard. But for us in 2020, you're going to see a lot more strategies that we're not going to compete against just S&P 500. market cap or also 2000 market cap that have great offerings out there, you know, that I recommend people look at, whether they're from my previous firms or others, but we're going to be offering

things that are one beta that have no leverage in them that can be used as more buy and hold instruments. We've talked in recent weeks about the fact that eventually these low expected returns that people have been preaching about for years are going to come. And what does that mean for people's tolerance for risk? And it is potentially something like this leverage, something that people are going to use to catch up. What are the costs involved in something like that? Is that something that's included in the expense ratio? Is that another line at them? How do people track that sort of thing? Yeah. So especially when it comes to the relative weight types of products, there is a cost to have swaps in the strategy. There would be a cost to use

an ETF if we're getting access to that particular exposure. And that's going to come out of your net asset values. You would see some degradation in return. But what's really great is now that we have a one-year track record of the products that were kind of a concept 18 months ago, now they actually have shown that they can deliver the returns that are expected with minimal drag relative to what you would see with just a long-only approach. Well, exciting times for direction. It sounds like you've got something for everyone or no one, but there's a lot. There's a lot here.

It's much more than just a triple levered performance. So I am excited to see what these things do. Dave, thank you so much for coming on. We really appreciate it. Thanks for having me. Thanks again to Dave and everyone in a direction for speaking with us. I thought one of the biggest takeaways here, maybe this is just because I'm a big market nerd, is thinking about how much goes into the operation of these funds. And he was talking about how big their trading staff is

and how many people it takes to run this stuff. I guess you don't really think about this when you just hit click to buy or sell an ETF on Robin Hood or whatever. There's just a lot that goes into it that you don't even think about. So hearing a little of that more operational stuff was interesting to me. Yeah, we take a lot of this for granted. I'm in the middle of reading a book by John O'Sara called a piece of the action that basically documents the democratization of finance going back to the money market fund and the credit card and all through time. And the fact that you're able to get exposure through products like this today, commission free nonetheless, it's truly, truly incredible. Yes. And again, buyer beware and understand what you're getting

yourself into. But I think Dave did a good job busting some myths about these funds in terms of how people have used them in the past versus how they should and how to really think about these things. And I think it changed my mind into some of this stuff too. All right. Thanks again, Direction and Dave. Animal Spiritspot at gmail.com. Send us some feedback and we'll see you next time. Thanks for listening.