Two of the most popular exchange-traded funds present triple-threats in both opportunity and danger for investors wanting to play the financial sector.
Photo: Oliver Quillia for CNBC.com
Traders at the New York Stock Exchange.
The Direxion Daily Financial Bull 3X Shares along with its sister bear fund are respectively the fourth and sixth highest-volume ETFs of nearly 1,000 funds in the $900 billion industry, according to Morningstar.
As their name implies, the two funds provide triple the moves of their underlying indexes—three times the move higher for the bull fund and three times the move lower for the bear fund.
That's because the funds are highly leveraged—or use a lot of debt—to maximize the bet. And unlike regular ETFs, which normally track a single index, these funds combine a small-bank stock index with individual financial stocks.
The result: investors can either win big—or lose big.
"The problem with these products is they move very quickly. If people are not prepared for the type of risk that is involved, it can hurt them in a hurry," says J.J. Kinahan, chief derivatives strategist at TD Ameritrade. "In theory they're great products. But without education on how they work and how they move they can be difficult to trade."
Because of the volatility in the funds and their potential extreme moves, the most effective way to use the FAS and FAZ funds is for short-term trading and not as long-term investments, market experts say.
For instance, an investor may want to use the bear-fund FAZ to hedge exposure to financials if there is bad news in the banking sector. Rather than having to sell the stock positions in banks and take the tax hit, the ETF can act as a quick guard against a downturn in the sector.
"The allure is for people who want futures-type action in a stock," Kinahan says. "People can use the FAZ as a portfolio hedge if they have really long positions. These are the types of things you are trading intraday."
Investors with stronger risk appetites but who have spent much of the year's stock rally on the sidelines also can use the triple-bull FAS to play catch-up.
The two funds have achieved average daily volumes level comparable to CNBC-parent and Dow component General Electric , despite being on the market since only November 2008, around the height of the financial crisis. Investors use ETFs because they are made up like mutual funds but trade like stocks.
"If you wanted to get aboard the train and the train has left the station, you can get in on a short-term basis before switching back to an unleveraged issue," says David Fry, a trader and publisher of ETF Digest. "You can catch up, basically."
But investors who simply think they can wantonly use the funds to get in on gains in the financial sector could be making a mistake, for a variety of reasons.
Double- and triple-leveraged funds have gotten a bad name in some corners of Wall Street in part because sometimes investors get fooled into thinking they're getting something they're not.
For instance, while the FAS and FAZ indicate they track financials, it's not the more common SPDR Financial Sector ETF that they follow. The SPDR XLF follows the Standard & Poor's financial sector, but the Direxion funds primarily track the Russell 1000 small-cap banks, though they also have much smaller allocations towards larger banks such as Citigroup and Goldman Sachs .
"So many traders and investors are using them, looking at their titles, and pretty much just judging a book by its cover," says John Gabriel, ETF analyst at Morningstar. "It's absolutely an issue of education and understanding of what you own and what you're trading."
In fact, the leveraged ETFs have inspired so much caution that many portfolio managers are being locked out of them as big trading houses grow leery of intensified scrutiny from regulators over the issues.
Another of the concerns is that the leveraged ETFs sometimes don't even track their actual benchmarks over time. Last Thursday's market plunge, for instance, saw a rash of trader arbitraging, and a disproporationate amount of ETFs plunged compared to stocks during the Dow's nearly 1,000-point drop between 2 and 3 pm.
"The problem with these doubles and triples is they don't correlate with the underlying benchmark over any period of time," says Kathy Boyle, president of Chapin Hill Advisors in New York. "They're really meant to be trading vehicles. That's very difficult for the average adviser—they're not set up to be that way. Most clients don't understand."
But for those clients who do their homework, this can be a good time to deal in the ETFs as the financial sector continues to dominate the news and trading can get unpredictable.
"This is kind of a holdover from the financial crisis going back into March of last year when financials just dominated the news," Fry says. "Financials are back in the news again, and they're going to remain there for a while."
