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ETFs Aim for a Speedy Ride in Markets
Direxion Portfolios
Seek Triple Returns
Through Leverage
By JOHN SPENCE
May 20, 2008; Page C13

In an attempt to create products that stand out from a crowded pack, an investment manager plans exchange-traded funds that provide three times the stock market's return, raising new questions about the risk of such turbocharged portfolios.

Direxion Funds has proposed the first ETFs to give triple the daily return of some mainstream stock indexes. Of course, these leveraged funds would amplify investors' potential losses as well.

Charged-Up Bears, Too

The new funds would track popular U.S. benchmarks, including the Standard & Poor's 500-stock index, Dow Jones Industrial Average and Nasdaq-100. Direxion also has proposed bearish ETFs that would provide identical leverage in the opposite direction, according to filings with the Securities and Exchange Commission.

Direxion envisions similarly leveraged ETFs for international benchmarks such as Japan, Latin America and emerging markets. There are also filings for sector funds, including energy and home builders.

The move ups the ante in the ETF industry's wider use of leveraged offerings. There are currently ETFs that aim to double the market's performance, but the planned Direxion funds would climb several rungs higher.

For example, if it is approved, Direxion's S&P 500 Bull 3X Shares fund would seek to gain 6% if the index rose 2%, although the actual return might be lower because of operating expenses and financing costs. The ETF would have a management fee of 0.75%, according to the initial prospectus.

Conversely, if the index lost 2% on a given day, then S&P 500 Bear 3X Shares would aim for a positive 6% return.

Power Plays

One reason leveraged and short-selling ETFs have been embraced is that they allow individual investors to more easily tap sophisticated trading strategies.

If they are particularly bullish on a sector, buyers can use leverage to magnify profits, although with more risk for potential losses if markets move against them. In this way, investors get more bang for their buck. They can invest fewer dollars in a leveraged ETF to get market exposure, leaving more capital to deploy elsewhere.

Inverse ETFs, meanwhile, give individuals the chance to benefit from market declines and also are a convenient way to hedge against losses.

Direxion Funds, previously known as Potomac Funds, specializes in leveraged index funds that give long and short exposure to markets. Its main rivals are ProFunds Group and Rydex Investments.

Direxion, based near Boston in Newton, Mass., manages traditional mutual funds that provide leverage, including some geared to give 2.5 times leverage. Unlike ProFunds and Rydex, it has yet to get into the ETF business.

ProShares, which is part of ProFunds, was the fifth-largest ETF manager at the end of March, with about 60 U.S.-listed products. The Bethesda, Md., firm's leveraged and short ETFs have enjoyed strong acceptance; quarterly net cash flows were the strongest in the industry, at $5.8 billion, according to Morgan Stanley.

"All of the ProShares ETFs target daily returns are equivalent to either 200%, minus 100%, or minus 200% of a stated benchmark," Morgan Stanley analysts led by Paul Mazzilli wrote in a May 7 research report. "ProShares ETFs are some of the most aggressively traded in the market and are primarily used for short-term tactical trading or hedging strategies, in our opinion."

Rydex also manages several leveraged and inverse ETFs, such as Rydex 2x Russell 2000 ETF.

Courting Controversy

If they see the light of day, Direxion's juiced-up funds likely will induce hand-wringing by critics, and the ETFs certainly wouldn't be appropriate for average investors. Leveraged ETFs usually dominate the top and bottom of the performance lists, reflecting their volatility.

Although it is difficult to determine who are the ultimate users of leveraged ETFs, anecdotal evidence points to proprietary trading desks and large financial institutions. Registered investment advisers who practice quantitative and tactical trading strategies are another base. Investors looking to ride momentum in the markets also might be attracted to leveraged and inverse ETFs.

However, the products don't necessarily deliver the stated leverage over longer periods, as a result of the arithmetic of compounding returns. This so-called tracking error may be compounded by additional leverage, said Mr. Mazzilli at Morgan Stanley.

Direxion declined to comment on the leveraged ETF filing.