FAS – Direxion Daily Financial Bull 3x: Keep Eye On Yield Curve

Introduction

Direxion Daily Financial Bull 3x Shares (NYSEARCA:FAS) is the famed passively managed fund allowing leveraged exposure to financials. It’s a market cap-weighted index of large US financial institutions with somewhat of a semblance to its distant and more widely known relative, XLF. Assets under management have increased to $1.95B since I last covered the fund as investors start to weigh back in on the financials sector.

Rather than revisit the intricate details of the fund, it is worth looking at any changes since my previous coverage. For money managers interested in structural detail linked to the package, I encourage you to research here.

Launched in 2008, the product makes up part of the family of increasingly prevalent exotic leveraged packages destined for day trading and portfolio hedging. The underpinning macro-economic factor influencing the financials sector is the yield curve.

That’s why it is so important to understand evolution in monetary policy to use FAS as a trading tool. It is worth noting, as per my previous research, that Direxion Daily Financial 3X shares is a leveraged passive investment aimed for tactical trading, not long-term holding.

As such, my recommendation on the package is neutral. As the name suggests, “daily” highlights the ideal holding period – product resets and compounding imply that holding for any longer may not provide the desired results.

The Current State of the Yield Curve

When dealing with financial services, the yield curve is essentially the only game in town. For interest sensitive securities like real estate, consumer discretionary or even financials, it is a key indicator to monitor.

Banks and financial institutions essentially derive their income from credit activities. With the yield curve essentially dictating the price of money, that is critical as it fixes margins within which banks operate.

And it has not been pretty for the US yield curve. With several different levels inverted, front dated maturities have moved above longer dated ones. Historically, this yield curve shape has always been a sign of recession. That makes for a possibly gloomy picture for the US economy particularly into the second half of 2023.

The US yield curve has been inverted for 6 months now, signaling increased probability of a future recession.

In normal times, the term structure of interest rates is generally upwards sloping with shorter dated maturities having smaller yields than longer dated ones. There are many reasons for this, liquidity, time value, and even the nature of market participants actively trading these securities.

The Federal Reserve acts on the shorter end of the yield curve by taking decisions to raise rates (tighten monetary supply) or reduce them (loosen monetary supply) Accordingly, the shorter end of the curve provides insights into expectations around monetary policy while much longer-term securities provides insights into expectations around the general economy.

For banks borrowing on one end of the yield curve and lending on the other, this makes for tumultuous times when those maturities invert. As a worst-case scenario, inversions generate losses. In a more favorable one, they deter capital from being deployed into the general economy.

The Fed Funds rate was raised by 50 basis points in the last monetary policy meeting. Decisive action is being taken to stave of 40-year inflation with the flipside of this being increasing costs of capital and a deep, enduring inversion of the yield curve.

Forecasting what happens next will provide an outlook for the financial services sector and FAS. If you are a believer that the Fed will take curative action by reducing rates following the onset of recession, then financials may not be the best place to be. Equities tend to increase as rates lower. This is likely to be less pronounced by financials more dependent on higher interest rates for revenue generation.

The Fed Funds rate has spiked as the Federal Reserve fights persistent inflationary pressures.

Key Traits – Financial Services

Because FAS is essentially a leveraged proxy of XLF, it is worthwhile understanding XLF traits. XLF, which covers financial services, makes up roughly 10% of the broader S&P 500 index.

Securities in the financial services sector tend to have relatively low valuations, book values and often offer a dividend distribution. Regulation following the Great Financial crisis has been extensive, forcing banks to ringfence assets and maintain certain liquidity levels.

The financial services sector tends to flourish during periods of GDP growth likely to be absent during 2023. Steepening yield curves are also characteristically good for the sector. Unfortunately, that has not really been the case – to the contrary, most recently the yield curve flattened and then inverted, telegraphing an imminent 2023 recession.

Product Recap

FAS provides 3x leveraged exposure to a market-cap weighted index of large-cap US financial institutions best described in XLF. The leveraged fund, that was originally marketed in 2008, is an open-ended fund comprised of a range of derivatives used to replicate leverage.

Accordingly, the fund’s managers deal in OTC derivatives, lend out underlying securities, and even pay a distribution (0.82%).

Management fees are high (0.92%) but remain within a tight band representative of leveraged ETF plays. Naturally, options markets also exist for this ETF making risk customization more practical. In fact, the fund’s short-term nature makes the use of options married to a holding an interesting set-up.

Fund flows reflect perhaps the lack of appetite money managers had for deploying capital during a forgetful 2022.

While the leveraged fund is essentially made up of a range of derivatives such as swap agreements, futures and other related securities, the underpinning securities delivering returns can be derived from XLF. A look at the historical % price change over the past 12 months v holding weight provides insights into overall returns.

Risk Factors

Risk factors for FAS are common among all synthetically leveraged ETF products. Daily resets occur on the fund (hence the name daily) implying sizable differences between expected returns and actual ones. Due to the sensitivity of financial securities to interest rates, monetary policy is a prominent risk factor.

Leverage is a major risk linked to the ETF and any money manager using the product should be well aware of its perils. Direxion Daily has an excellent leveraged and inverse leveraged ETF education center that you can check out here. Counterparty risk linked to derivatives used to structure the leveraged ETF is a risk as is market price variance risk. Before using any leveraged ETF, make sure you fully read and understand the term sheet.

The package is wholly exposed to the US equity market and regulatory risk linked to the financial services industry is also a factor. The banking industry has been heavily scrutinized since the Great Financial crisis, heaping the sector in rigidity.

Comparative analysis FAS

Key Takeaways

For readers familiar with my previous ETF analysis, they are likely to have a solid understanding of the underlying fund mechanics. Here the important takeaway is to understand critical macro-economic factors impacting financial services, namely the yield curve.

With the figurative price of money, as described in the Fed Funds rate, at multi-year highs, one could expect upside for risk assets. This is not necessarily the case insofar as higher rates often negatively impact equities. In any case, FAS makes for a trading tool and not a long-term security.