Markets’ reaction to the political tumult that rattled Brazil last week underscores the risks facing investors who use so-called leveraged exchange-traded funds in a bid to turbocharge their returns in highly volatile areas.
Even in the high-octane world of leveraged ETFs, the 48% drop in the Direxion Daily MSCI Brazil Bull 3X Shares on Thursday stood out. Its one-day fall was bigger than the drop in leveraged products tracking financial stocks during the great recession, and it outpaced the wildest plunges in products that hold perpetually volatile gold miner stocks, according to Charlie Bilello, director of research at Pension Partners. The ETF subsequently rebounded 18% on Friday.
By comparison, the iShares MSCI Brazil Capped ETF, which tracks the same index but doesn’t have leverage, dropped 16% on Thursday after reports that Brazilian President Michel Temer was involved in an alleged bribery. Mr. Temer vowed that he was innocent.
The concept of using an exchange-traded product to multiply the returns of a given asset increasingly has been applied to riskier investments. In recent years, fund firms have created leveraged products tied to emerging markets like Russia and commodities such as crude oil. The Securities and Exchange Commission has increased its scrutiny of these products.
“High volatility and leverage don’t mix very well,” Mr. Bilello said. “It’s interesting because the most popular ETFs are the most volatile.”
Leveraged ETFs deliver amplified price moves on a single day. Holding these products for days or weeks, especially when markets are volatile, can result in price swings that are exaggerated well beyond the stated two or three times leverage. For instance, the unleveraged iShares ETF is up 2.1% this year while its triple-leveraged ETF counterpart is down 17%.
In the case of this Brazil ETF, investors face another risk: currency fluctuations. U.S. investors who buy international stock ETFs trade their dollars for the local currency, effectively making them long both stocks and the real in this case. That means that even if Brazil’s stocks rise, a falling real would erode the ETF’s gains. The value of the Brazilian real dropped 7.1% against the U.S. dollar on Thursday, though it rebounded by 3.8% on Friday.
Sylvia Jablonski, managing director of capital markets for Direxion, the company that offers the ETF, said that while she wouldn’t advise the product as a long-term investment, it can be a good trading tool.
After the size of the ETF roughly halved on Thursday, investors put more than $60 million of new money into the product on Friday. When the ETF’s share price rebounded that day, the size of the ETF ballooned to over $118 million, its largest ever, according to Direxion.
“Someone is betting largely that Brazil is going to rebound after falling almost 50%,” said Mohit Bajaj, director of ETF trading solutions at brokerage WallachBeth Capital.
Investors may have also piled in as part of a larger trade, according to Ms. Jablonski. Some may have bet against the un-leveraged Brazil ETF or the stocks it holds, and then bought the leveraged version as a hedge.
Day traders, who often like to make bets around big market moves, buzzed about the leveraged ETF as the news unfolded. On StockTwits, a popular forum for traders to discuss investment ideas, there were more than 900 messages on Thursday about the product and nearly 700 on Friday, up from virtually none the week before.
– Chris Dieterich contributed to this post.
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May 23, 2017 at 01:48AM
from Ben Eisen
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