Animal Spirits Podcast - Talk Your Book: Single Stock ETFs

Episode Date: September 12, 2022

On today's show, we had David Mazza, Head of Product at Direxion to talk about the use cases and risks of investing in single stock, leveraged, and inverse ETFs 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. Direction has just announced single stock daily leveraged ETFs. These would have been perfect for Michael circa 2014 when he was trading. 2010. Okay, when you're trading, okay, sorry, when you're trading the earnings days for these companies and buying options, this is a way to do it. You can either bet four or against. So go to Direction.com to check out more for how to bet either bowl or bear for Apple and Tesla.

And that's Direction with an X. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik 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 Rithold's wealth management may maintain positions in the securities discussed in this podcast.

Welcome to Animal Spirits with Michael and Ben. Michael, one of the things I think a lot of pure finance people brain will think is that everyone should just be a long-term buy-and-hold investor. I'm partial to buy-and-hold myself. But I think one of the things that the last few years has taught us is that just people in general like to gamble. And they like to take some of their money, whether they're going into. hand up yeah whether they put it into sports betting apps i went to a wedding this weekend and all i heard my cousins talking about was how they loved betting on the sports betting apps and people opening robin hoodcuts all this stuff and i think on the one hand you could shame people and say why are you

doing this on the other hand i think you can say you know what take some of your money and have some fun with it and i think that's okay i think that there can be room for both for some people that realize you know i'm human i enjoy this there's something i get out of this like me and you at the blackjack table. There's something that you get out of it that's just kind of fun to do and it's entertaining. And then there's also the people who say, I'm a short-term trader. I know I've seen that the ads are stacked against me, but I'm going to try it anyway. I'm going to head. I'm going to do all this stuff and do something with my account. And so I think it's okay to admit both of these things. Both of those approaches. Cannot agree more. And Directions suite of ETFs accomplishes

just that I do wonder, we didn't actually, we didn't get into this with Dave. And I'm not even sure that you can know this information with the ETF wrapper. What percentage of the trading in these tools is done by retail versus institutional? And I do wonder if that varies by product as well, like if some products are more likely to be traded by retail versus hedge funds and whatever. I just think this whole thing with individual stocks and there's also individual bonds now in ETFs, it's interesting to me how quickly this seems to be happening. And this is the kind of thing that is probably not going to slow down anytime soon, right? Where you can do that. this? Nothing slows down. Nothing ever slows down. Yeah. So they have these strategies. Apple and

Tesla, which have to be the two most popular stocks that there are. What else would you even put in the ballpark there for most popular stocks besides the meme stocks? For wide audio, yeah. Most traded, I guess. I have to imagine that these things are going to go crazy on earnings season. So you can bet either... It makes sense. Let's say that you're an Apple person. You've held the stock for seven years, and they've got an iPhone release or whatever, or an earnings, or whatever the case might be, and you want to put on a hedging trade. Honestly, I don't think that's the dumbest thing I've ever heard. Not even close to it.

I understand. I get it. And I think we've seen people have the ability to blow themselves up with options because options are not that easy to understand. There's a lot of stuff about options I don't understand. True. If you want to hedge, all kidding aside, this is probably a much better way to do it than with options when you're talking about all a million variables that most people probably don't

understand. There's two CFAs here. Could you and I do options math right now if we had to? If my life depended on it, probably not. Right? No chance at hell. Okay. We talked to Dave Mazza.

We've had mine before from Direction to talk about this. And Michael just wants to make sure everyone knows it's direction with an X. There you. I've said this before. When I first started trading these products back in the day, 2010, I was trading FAZ, the triple lever bare banks, ETF. I thought they were called Direction. I don't know if I thought they were a foreign company, but that's what I call them.

So F-A-Z- Turns out it's direction. F-A-Z is still around as a fund. That's still there. That's pretty impressive. Three times finance bear is still here after a 10-year-long bull market. That's impressive. It's got a soft spot in my heart. All right.

Here's our conversation with Directions Dave Mazza. We're joined today by Dave Mazza. Dave is the head of product act direction. Thank you for coming back on the show today. Hey, pleasure to be here. We're going to talk all about a new thing that's going on in the ETF marketplace. These are single-stock ETFs, which is something that I probably never thought I would say a single-stock ETF.

Dave, when I was coming up in the industry and I wanted to get down and have a good time, I would buy options. That's how I had fun. What's with these single-stock ETFs? What's wrong with options? We can't just gamble with options anymore? Well, first and foremost, thanks for having me back. But I would say that you're on to something.

So these products, like all leverage in and versus ETS, and I want to be very clear about this, are intended to be trading tools. And there are folks out there that say the ETF structure should only be used for long-term investment vehicles and the like. And from spending over a decade at State Street, I can appreciate some of that sentiment. However, really what we're talking about is an investment vehicle that offers access to, at this point, a multitude of solutions. Those could be across different asset classes, whether it's stocks, ponds, commodities, everything

in between, different solutions, like what some other firms are doing, sort of disrupting the structured note markets and offering more defined outcomes in ETFs, or in this case, now taking the ETF structure, which allows potential for amplified returns on a daily basis or on the upside or downside to single stocks. And this is important to note, if you're not interested or you don't have the aptitude to make that buy, sell, or hold decision on a daily basis, then these products are not for you. But if they are, they actually can give you greater certainty than potentially using options to access both potential for upside or for hedging purposes. I suppose part of it is this is just easier for most people to do than figuring

know how options work. Is that a simple way to explain it? The challenge of options is a few things. I learned early on in my investing career or an option in some cases trading that there's always someone who's smarter than you or a bigger computer. And generally, when it comes to options, that's pretty important. And now, on one end, it's great. There's been a democratization of access to really a lot of financial products that happened with many off-star brokerage firms or as other firms have been absorbed by larger players, more people can access options accounts. But you're trading on margin. They can be very complicated to understand.

They can be very costly and you can lose more than you put in. To your point, there's a lot of ease of use here with the ETF structure being applied to single securities. And you don't necessarily have to worry about a margin account. You can't lose more than you put in. And also, you have some greater certainty of cost that you may not have with options, particularly thinking about trying to unwind positions that may have been put on in a different market environment. Also, with options, I feel like when I used to trade these things, I would buy something

and then immediately you're down 13 percent as soon as you go to the account. So to your point, there's all these implied costs and explicit costs that most people probably are not aware of. Can you talk about, well, first of all, direction has been very very important. successful getting these products to market. You told me that the suite of ETFs is now up to over about $25 billion. So obviously there's an enormous demand from investors for the sort of thing. Let's talk about how these work. In terms of how you're getting exposure, levered exposure inside of an ETF, are these done using swaps, are their options inside of these? How exactly does that

work? Really good point. This is something where folks sometimes get hung up. So what we're really doing is, again, offering amplified exposure on the upside of the downside on a daily basis in these products. When we refer to a bull fund, that means amplified upside potential. So in the case of the single stock ETFs that we're talking about for Tesla and Apple, that's 1.5 times on our index-based products that can go up to three or others are available at two. The same can be said when we talk about bare products. So those are inverse 1x, inverse 2x, and 3x. The way we're actually managing these funds is primarily using something called a total return swap. Sounds complicated, but really it's a contract with counterparties. And in our cases, we're working with a wide

range of them to deliver that amplified exposure. You could do so with futures, you could use options, but have you. But again, with these total return swaps, effectively act as contracts to give us the certainty that we're going to, on a daily basis, get the particular 2x or 3x exposure in the case of an index-based product that we're looking for so that we can track that index. And that's what's interesting. If you take the time, I'd recommend folks, too, if they're interested, look at the prospectuses, and it will say the objective of the fund,

like the objective of a traditional ETF is to track an index. The objective of this fund is to amplify the tracking of that index in a daily basis. You have a bowl and a bear for Apple and Tesla each. Are these two stocks far and away the most heavily? traded stocks in the market, is it even close? I have to imagine, like, the interest in these two stocks has to be great on all of them. Maybe I'm wrong. Is that about fair? Yeah, so the way that we're thinking about it is, and we have filings for other securities and full transparency, is to offer exposure, again, 1.5 times on the bull side, and then 1x times on the bare

side. And there's really different utilities here for securities that have large market caps. Relatively in this market, I guess you could say nearly everything does, has higher than average volatility, Tesla especially, and deep volume, whether that's deep volume at the individual security level or in the options market. And the reason we want that is for two reasons. One is that we can be confident effectively managing these products and getting access to the exposure that we need to and also at the same time putting us at a position where we believe that there will be interest. And as we know that these products have existed in Europe for some time and they've been managed successfully. Of course, the European ETF market is extremely different in many cases in the

U.S. market. But we believe that because folks are interested in expressing short-term opinions on Apple and Tesla or looking at hedging the positions because the stocks are really in some ways ubiquitous in investor or trading portfolios, that these would be two great places to start from an offering perspective. Why is the European fund industries, seem like it's so far ahead of the U.S. in terms of getting products through. You'd think the U.S. would be at the forefront of a lot of this. So the European, they get the Bitcoin and crypto funds first. They get these first.

Why does that seem to happen that Europe is ahead of us in that? It's really interesting. It's something that I've spent some time thinking about is that part of it's the regulatory environment. Let's just be frank about that in a different regulatory framework. There's going to be different products that will be available. I think in addition, it's also just, I think, different appetite. So the European ETF market has a much greater number of funds, but it's also very disparate.

So there's listings in London, listings in Germany and Italy and France, everywhere in between Ireland, because one, we talk about Europe as if it's a country. Obviously, it's a continent. And I don't mean that to be facetious. It's just that we always compare U.S. versus AMEA or U.S. versus APEC. But underlying that, it's a very different market, different countries, different exchanges, and different types of sort of appetite. that we might not see in the U.S.

So what I do believe is that we are, in some case, in the U.S., often thought of as a leader, in other cases when it comes to kind of investment product access, I think you're right. There are other places that are ahead are just frankly different. Do you have any insight into investor turnover inside of these products? Do you see investors using this appropriately, or do you not necessarily have that level of transparency? say? So one thing that we have that it's called the implied holding period, and we spend a lot of time looking at this because we want traders to use these products appropriately. And that's why the first thing I said, I say this at nearly every forum I get is if you're not either interested,

comfortable, or have the ability to monitor their positions daily, to make that buy, sell, or hold decision, these are not for you. And I want to be very clear about that. And a lot of, I think, the misconceptions about how these products are used are because of that. These are daily tools. So when we look at this implied holding period saying, well, what's the turnover? What's the velocity of trading relative to either the shares outstanding or assets and or management? And in the vast majority of cases for our funds, particularly those that are more mature, is that you have very, very high trading volume compared to their assets. And that's a good thing, because that means people are on average, not holding them for longer than they should. And what we also have

noticed is as volatility increased in 2021 into 2022, that holding period moved down. So in some cases, our bare funds have holding periods lower than a day, which is great, because the bear funds, particularly like a put option, can trade away from you very quickly. I was very pleased to see that, particularly as that holding period tightened because we did see a large increase in interest in our leverage and inverse ETF suite at the same time. So you, would like to see if a lot of these products, the average daily holding be a day or less then? That would be what you'd want it to be, probably. That would be ideal. So if I see it within three-day, two-day period, one-day period, that's exactly what you're looking for.

What's interesting, though, is if you look at even the three largest SMP 500 ETS, IVV, V-O-O, and SPY, those have very different implied holding periods. We tend to see V-O-O have the longest, IVV somewhere in between and SPY lower. Why is that? Well, over time, SPY has become more of a trading vehicle. It has a very, very deep options market. It's used, again, in so many different ways, which has been great for the success of that product. The leverage and inverse space, it's even smaller. I love seeing inverse funds, the bare funds, have holding periods less than a day to your point. Bull fund, a day or two works. And the misconception is that you can never own whether it's a single stock leverage an inverse ETF or leverage an inverse ETF on the S&B 500 for longer than a day.

That's not necessarily true. You can do that if you make that decision to do that. If you're just kind of trying to put money in here to amplify returns over the long run, not going to work. If you go on YouTube, you're going to find people that says it's worked. And I'm sure there's been people that have been very successful. I advocate against that, to be quite frank, because like anything, the trend. friend will be your friend until the market turns away from you. So that's not how these products

are constructed, nor that's how they're intended to be used. Dave, let's talk more about that for a second because we get emails all the time, actually not true. We used to get them all the time, particularly in early 21, I guess through the end, we will get emails from young people asking about using these leveraged products for the long run. And my advice, and it sounds like it's similar to your thought on this, is that I get it, I totally get it, but I don't really know many people. and I don't care of how much or how little money you have, have the stomach to sit through a 70% drawdown in 30 days. That's absolutely correct.

So maybe there are folks, to your point, that are able to do so. I know I wouldn't be. Nope. No chance. I don't think either of you two would be either. And I'm joking here, but I don't mean to because I'm sure there are people who have used these products as they're not intended to be used. And I want folks to understand that if you, again, have the interest or aptitude to amplify

exposure on a short-term basis, these tools can be excellent for you. Or in the case of let's talk about a long-term holder of Tesla or Apple, and let's use the example of Apple for it. We know that they're going to be announcing the iPhone 14 in the early part of September. What if you love the stock? You've owned it and bought more of it through every drawdown. And you've created a significant get them out of wealth for you, however many zeros that may have, but you're concerned that this might be a flop. You could use AAPD in this case to have a short-term hedge on that day, which may give you more certainty than you would going out buying, trying to execute a put-option trade if you're concerned about that. That way you don't have to touch your longholding,

which may impact your taxes, what have you. There's really a utility for the inverse side as a hedging tool, again, on a short-term basis, but it's not something that if you want to express a long-term view on Tesla or Apple, you should probably buy the common shares or use other tools to do so if you're going to set it and forget it. If you want to use something to give you that certainty on shorter time periods, these products can be powerful for you. I know that these products are still relatively new, so you haven't tested this out yet, but do you think come quarterly earnings time, you'll see a 10x increase in volume for these probably, like the day of where people want to bet when they know there's going to be some volatility?

I would certainly expect that. There's a couple of use cases for this, is that if people want to express that view either on the upside or downside around earnings or the day or so around those events, these are the tools that you could look for to be in your toolkit to make that happen if that's what you're interested in doing. This sounds like a silly question, perhaps, but is there any potential counterparty risk with these swaps?

Always a fair question and frankly a good question. And certainly, yes, there could be. That's something that we know exists, which is why we use a multitude of counterparties to gain the exposure. And we monitor the financial health of the firms we're working with. That first and foremost, because we're offering tools that are intended to be trading products that offer amplified returns, both in the upside and the downside, we take kind of a risk-first approach to managing them. We invest heavily. either in the trading tools that we need and in the personnel that we need to monitor both the relationships that we have and what's kind of happening with the firms themselves. With that being said, we've never seen, at least in the ETF structure, issues that have impacted the funds at direction or that I'm aware of. ETS are a different story, of course, because that's a direct, you're taking on direct credit risk of the issuing bank behind it. And that's something where if folks who are using those products should have an appreciation for. And that's, I think, a conversation that the ETF industry has pointed to for some time.

In this particular case, yes, we're taking on some trading risks to do so, but we have a diversified number of counterparts that we work with. And again, we invest in understanding who those firms are and what their financial health is. I know you're not an accountant, but any other special tax situation with the swabs or all these all just normal short-term gains or losses. Yeah, so I can't speak to any individual. tax situations that folks may have trading these products, but yes, that's the right way to think about it. So there's also other tools at our disposal in certain cases like using futures contracts

or things of that nature or the underlying ETFs themselves, of course, to get kind of that initial one beta exposure, which we use. But there's not necessarily anything kind of inherent differently than how the swaps would be taxed themselves. I'm curious if you notice anything different now that we're in a downtrend. So on the one hand, when things are going great, people probably are more willing to use leverage. But on the other hand, people tend to trade more when things are going bad. So do you notice a huge uptick in the trading of your products during a bear market? Or do you think people are more averse to using leverage and then you don't see as much happening there? I think that's a really interesting question.

I debate myself about this all the time. We've become accustomed, both as I think long-term investors and as traders, that bear markets recover very quickly. Look at the COVID crash. In some cases, you could even point to what happened in 2018, go back to the sovereign debt crisis. The financial crisis had a really, really nasty drawdown to fully recover. You've done a lot of research on this yourself, so I'm telling you something you know. But the March 2009 period began kind of a sharp, at least recovery in the markets. The question I would have for folks who use our products or just in general is, are we going to be in a sustained market where returns are generally more. volatile, but they might still go up over time, but the long-term sort of compounding is lower.

And I think there's some evidence to suggest that we are, 2022 is becoming a bit of that environment, barring a pivot from central banks or from a fiscal policy side, which doesn't necessarily appear to be the case. But what we are seeing this year is, as our assets have come down, our flows have increased and our trading volume has increased. So it tells me, traders are not necessarily stepping back from the market. We'll see if that changes. If this continues to occur for six, 12, 18 months, I'm not sure. But to me, I think what I often like to think about is in markets like this, either you extend your time horizon or you shorten your time horizon or a combination of both. And by that, I mean, extend your time horizon because the period we're in is extremely

volatile. Returns are going to be nasty. Maybe you don't want to be looking at your account every five minutes, particularly if trading is not in your blood or of interest to you. Or if you are more apt or interested in taking advantage of volatility, well, this is what it's for. So you can shorten your time horizon, be more nimble. Leverage and inverse products are a tool for you in that environment. But we also talk to folks who do both. They work with advisors or they are an advisor and they have long-term time horizons for most of their wealth or that particular bucket. And then they use other tools to take advantage of the volatility that we're seeing. To your point about things being more volatile and not having these V-shaped recoveries,

I was looking at this morning. The SMP 500 has been below its 200-day moving average for 98 days, which is the longest period of time spent below that moving average since the GFC, believe it or not. And so we've seen investors react. Last week, Ben and I were talking about some stats from Ben Johnson from Morningstar, who noted that July was the fourth consecutive month of outflows from U.S. mutual funds and ETFs, which is the longest streak since their data set began all the way back in 1993. So I don't really have a question, but just like, I don't know, your general thoughts about

what's going on. I think that's kind of consistent to sort of what I've been debating in my own head is that what are the most dangerous words in finance is this time different? In many cases, I don't think it is different at all. It's just a lot of people investing, and I think not to date ourselves, the three of us have not invested in a market environment like this. And in fact, I'm a lot older than I even was in the GFC, and there's many folks that have coming to business who have never seen anything other than a supportive Federal Reserve,

other central banks, no inflation. In fact, in some cases, disinflation, that's going to be a challenge. And I think the investor psychology and that component of it is underappreciated, especially if now we have, again, even older millennials for most of the Generation X environment, have not seen their working years, either if they're traders or long-term investors, in anything like this. And that's why, to me, this is when people, the naysayers kind of talk about what experiments is happening with central banks, what have you. I think it's true. I think we're living in one that a lot of folks I've not seen. And time will tell if that means that we're going to

have a broad race retrenchment of long-term investing. I think that's for most, probably the worst thing unless you're overextended than you could do. But I think the jury remains out. Before we got on the call today, we actually were talking about some funds that you guys are going to close. And I think that is just the nature of the thematic business. That's bound to happen either from bad timing or just sometimes these things just don't get traction. I'm just curious how that process works for you all and how you decide on a fund that just did make it for a reason, how you come to that decision and what the cost benefit of that is. Yeah, it's interesting. And Unfortunately, at direction, I think at even larger issues, you can afford, meaning as a business, to have funds open for longer than a single person shop or a smaller firm.

So there's some benefits to scale. With that being said, as the ETF industry has matured, I believe ETF investors, ETF traders have been more comfortable that certain funds may not become commercially viable and they may close. And that's not a great experience if you're interested in a product. we take that into consideration? With that being said, I think we also know that winners or losers generally are chosen very, very quickly. And I'm of the belief as someone who's responsible for both developing products and sort of stewarding them, that if a fund is not of interest to a wide range of shareholders, because we look at the shareholder account, and it doesn't necessarily see, I wouldn't even say significant, any regular trading volume, then unless you think

something's going to change, meaning it's just not right for the market environment or this particular or something unique from that perspective, then it's probably best to close it so that someone doesn't have a bad experience accessing it or trading it. That can happen when funds aren't large and have robust and deep liquidity or assets around them. So we really really, weigh, well, what are the number of, one, simply assets trading volume, but what are the number of shareholders? Is it something unique about the market environment, right? Is it a value fund and we've been in a growth market? Or how does that stack up? Are we hearing interest from our clients? And then we'll make the decision to shutter the fund, but that doesn't preclude us from

introducing new products to the marketplace. There are some firms and some folks who say, never close a fund, because there's always an example of this ETF that sat around for a while and and then it became a billion-dollar product. I will fully acknowledge that, but those cases remain few and far between. As far as investor appetite or trader behavior, we've seen some wild moves in the bond market, particularly on the short end of the curve. Can you tell by looking at either asset flows or volume? If you knew nothing and all you saw was your lineup of ETFs, would you be able to paint a relatively accurate picture of what was happening in the market, do you think? I think that's actually interesting.

So something I found sort of fascinating when I first moved to direction is that we generally have a pulse of what's happening for short-term sentiment. I would caution to say that that's not a pulse of sort of what maybe the long-term sentiment is because these are trading products. But what's really interesting, so for example, this year is we've seen an uptick in volatility, or sorry, in volume in our inverse products or bare products. And that's a good thing, because people are looking either for hedging exposures or to take advantage on the upside on a short-term basis as markets go down. But there are certain cases where we've seen holding periods shorten, but also people looking to buy drawdowns or trade the dips that occur in a space like semiconductors. So it's not kind of a one-size-fits-all approach. The same to be said when looking at our long-term treasury funds, what have you, because, of course,

the volatility there has been pretty sharp. So I actually like to sometimes compare leverage it inverse flows volume compared to the larger industry to see, hey, is trading sentiment consistent with what's happening with long-term sentiment? Don't do that over a day or two because generally it can be very noisy. If you're seeing consistency over weeks, months, it's probably going to be telling you something about sentiment. Dave, this was a lot of fun.

Thank you so much for coming on today. We appreciate the time. Thanks for having me. Thank you, Dave. Thank you, direction. Direction withanx.com. Animal Spiritspot at gmail.com. We'll see you next time.