The probability of an equity market correction over the next few months is slim to none, so there co...
Why Direxion Doesn’t Want You to Buy Its ETFs
01/23/2012 12:45 pm EST
It’s not often that a fund company tries to discourage investors from buying, but Direxion’s Dan O’Neill explains why his company’s leveraged and inverse ETFs are not appropriate for most investors. He also details why the ETFs are best used as short-term investments.
Kate Stalter: Today, I’m speaking with Dan O’Neill, president and CIO of Direxion.
Dan, a few weeks ago, I spoke with your colleague Ed Egilinsky about the Direxion Funds, but I thought today, maybe you could answer a few questions for us about the Direxion Shares, the leveraged and inversed ETFs. One of the first things I was hoping you could talk about was that you view these best used as short-term instruments, not as long-term buy and hold investments.
Dan O’Neill: You’re exactly right. The products that you spoke to Ed about, the buy-and-hold mutual funds, are meant to be used by people who are buying and holding investments, but want products which are tactical within.
The leveraged indexed ETFs are used by very tactical investors, and so there we have bull and bear funds. They have daily betas, which means that essentially they’re to be used by people expressing a very short-term view of the markets.
They’re not appropriate for investors. You have to have the right attention span and risk tolerance, and essentially, they’re good for traders. They’re not really good for investors.
- Also read: Critical Shortcoming of Leveraged ETFs
Kate Stalter: You were alluding to something that I wanted to ask you about next, and that’s the strategy of utilizing the leveraged ETFs to take advantage of both sides of a trade. Can you give us an example of how that might work?
Dan O’Neill: Well, historically, I think most investors and most market participants have been long only, and so if you have a view on the market, if you think the market is going to go up, obviously you buy the particular stock or ETF or mutual fund that would express your opinion.
If you think the market is going to go down, the most you could do was get out of that position, but you couldn’t profit from a decline in the market if you decided that the market was going to go down.
What I think has gone a lot more recently, and especially with the rising popularity of ETFs, is that investors can now look at the market two ways. They can look at it to go up as they have traditionally, but they can also look to participate if they think the market is going to go down.
So, we have bear funds, and we’re not the only providers, but we have bear funds, which are long investments for you, so you don’t have to locate and short a particular security. You buy a long investment.
What we do is we build the portfolio so that it profits if the market goes down, the particular index that it’s targeting, and it will decline if you’re wrong in the market or the index goes up. It’s inversely correlated with the performance of the target index.
Kate Stalter: Explain how one might use these instruments to take advantage of both sides of a trade, then.
Dan O’Neill: Sure, 2011 probably illustrates the point. For the year, the market was very flat. By the market, I should be more precise. The S&P 500, for instance, was down slightly—was probably up slightly on a total-return basis—but there was a lot of drama within the year.
The market was pretty strong through the first half of the year, then had a terrible sell-off in August in response to what was going on in Europe and some other things, and then rallied quite a bit towards the end of year. There were several different markets within that one year.
If you were a tactical investor, you might have participated in the upside and then gotten out. You might have recognized the market was overbought in August and shorted it. You had a variety of different entry or exit points.
It’s not always easy to get it right, about when to get in and out of the markets, but if you’re a tactical investor, you will look at the market. You’re not deferential to the market. You question whether it’s going to continue going up or going to continue going down or what’s going to happen, and then, you can make investments based on your sense of where the market is at a given point in time.
Kate Stalter: Now, one of the things you had mentioned previously is that these are really intended for sophisticated investors, so for people who are listening to this interview today, how can they determine if these would be appropriate for them?
Dan O’Neill: Right, that’s a great question. I think just because you can do something, doesn’t necessarily mean you should, and I think that that applies to our products.
There’s an awful lot of, in the ETF world in particular—and we would be at the cutting edge of this—there’s an awful lot of products out there. It used to be that ETFs were broad equity market indexes—the S&P 500, things like that. Now, you have narrow sectors, our products are leveraged. They’re inversed and leveraged.
So the question is: Don’t let the product drive your risk appetite. You have to have the right risk appetite.
You have to be highly tactical, and what that means is short term in nature. You have to be very interested in the markets. If you’re the kind of person that is going to put on a trade and come back to it in a month, that’s way too long.
You should be the kind of person who’s interested in the markets on a daily or weekly basis, and in most cases, you need to have an expectation of what you want from a trade, and I think this important.
Most investors might say, “Oh, I’m going to put money to work in dollar-cost averaging, and I have an expectation that through time markets will rise.” That’s sort of the Vanguard approach, which I think is excellent for some investors.
But for other investors, they’re not as deferential to the market. They might say, “I think that the market is going to go up or down here 5%,” and they have a strong opinion about that.
- Also read: Know Margin Rules for Leveraged ETFs
If you’re that kind of investor, the products may be appropriate for you…but if you’re generally more passive and you think you have general expectations or long-term expectations, you should stay away from these sorts of products. We use an inelegant analogy: these are microwave ovens, and you wouldn’t try and cook a turkey in a microwave. So, this is for short-term quick trades, not for long-term investments.
Kate Stalter: Dan, that leads into the last thing I wanted to ask you about today. You must be well aware of the controversy and criticism surrounding some of these products. Can you address that, as well? Do you believe there’s some misunderstanding in the market place about how these funds should be used?
Dan O’Neill: I think that most market participants should not use these products…and I’m not sure what the proper number is, but let’s just say 95% of market participants should not use these sorts of products. Because they’re looking to invest for longer than the timeframe for these sorts of products.
Having said that, the turnover in our leveraged ETFs is remarkable. They are traded highly actively. We think that overwhelmingly they are used appropriately by people who understand them, who are tactical in nature.
It is certainly the case that because they will always be products that are used by a minority of the community, they don’t suit the eye of an enormous portion of the community. Most traditional investors look at these things and say, "Oh, I wouldn’t use those," and therefore there’s something wrong with them.
There’s nothing wrong with the products. They work well. They work exactly as they’re designed. They just don’t suit the eye of an awful lot of people. But we think that the controversy is more a function of complaints or criticism coming from people who never will use the product, as opposed to from people who properly use the product.
The people that use the product tend to like it very much. They understand the risk. They use it. They either make money or lose money. But they feel like the products work exactly as they’re designed.
An awful lot of the criticism comes from people who look at them quickly, say these things don’t make sense, and they want to criticize it. But they’re not the intended audience anyway, and so we get a little weary, I would say, from criticism from people that are never going to use the products. But we’re sort of used to it at this point, and we just try and educate people.
I think this is unusual for a firm which is trying to create interest in its products, but our expectation is that most people should not use the products, and so we are trying to sort of filter out the majority of people and identify potential clients who have the right mindset and risk tolerance and educational level for this.
It’s an unusual product, but the fact that it’s unusual does not mean that there’s anything wrong with the products.
- Also read by Howard Gold: Leveraged ETFs…Worst Investment Ever
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