Talk Your Book: Where Leverage Comes From

0:00Today's Animal Spirits Talk Your Book is brought to you by Direction. To learn more about investing in Direction's products, go to directionwithanx.com.

0:32maintain positions in the securities discussed in this podcast.

0:39Welcome to Animal Spirits with Michael and Ben. I've told this story before, but I want to take for granted that all of our listeners have been listening to every word that we've said. I started using Directions products in the early days, probably 2010. I used to think it was called Direction because, you know, what did I know? You were an early adopter. What did I know? I remember I was a part-time worker. What's that called? I was a temp. Temporary employee. That's what it stands for. I was a temp employee at... I was going to say it's called unemployed, but no. You actually did have a job.

1:10Okay. No, literally. I was a temporary employee at Citi. Not that you asked, but what did I do? I was watching the training videos, the harassment videos, the compliance videos, just to make sure that they did what they... It was horrendous. but hey those are those are tough days you gave gave some notes to the people on on the harassment videos but not to the people making them not the people watching them anyhow in order to you know to pass time and to tickle the itch that i had in the markets i was trading directions products on my blackberry from my desk and uh it was great fun i bet the ones that i was training i was late to the game i was training the the now mind you this 2010 uh you know several months after the stock market bottomed, banks had already gone down 90%, whatever it is.

1:57You know what this genius idea was? I'm going to short banks with leverage. So you were banking on the double-dip recession. I was an FAZ guy, which was the financial bear. And credit to me. I learned very early how these products work. These are trading vehicles, as we'll get into the conversation with Ed. These are not to be bought and held. What are you laughing at, Ben? Nothing. Sorry. I could see you smirking. So Direction has come a long way since the early days when I first found them. They do a lot more than just leverage, although that is their bread and butter. And we have a lot of fun talking.

2:31$30 billion in assets, which I'm sure there's a big fluctuation. The most interesting thing about this conversation that we had with Ed Ed Golinski, who we've had on before, is you were kind of asking him, do you think most of the people who follow your products and use your products, because most of them are meant to be very short term in nature are trend followers. And he said, sure, there are some trend followers, but there's a lot of people who also try to like top call top tick or bottom tick these products, which I think is way, way harder, especially in the short term. If I'm a short term trader, trend is the only thing I care about.

3:02And it's funny that people still I think it's just like you assume you're not a you're not a short term trader. Listen, if I'm not speaking for the traders, speaking for the traders, we like to assume that there's extra points for difficulty. Like as if you make more money catching a bottom or a top. Oh, called it. Nailed it. That you do just making money just in the direction of the trend, which obviously is harder and dumber, but our brains are broken and that's just the way it goes for some of us. It feels weird to say, I'm going to buy this thing that already went up a lot because I think it's going to go up a little more.

3:34And you see this thing that went down a lot and you go, oh, it can't go down any further. And that's usually what happens though. They keep going in the trend if they were going at least real time. Oh, yeah? Watch it. Can't keep going. Yes, I can. But that was interesting to me that people tried to do that because that's the opposite of what I would try as a strategy. That's what you think. If I ever did. You don't know what's... Ben, get into the arena. Try some things. All right. Here's our conversation with Ed Egelinsky.

4:00We're joined today by Ed Egelinsky. Ed is the managing director and head of sales and distribution and alternatives at Direction. Ed, welcome back. Thanks for having me back. When I think of direction, I think of the leveraged ETFs. I think that's where you made your bones. I don't know where that phrase came from, but not from me. I don't know where it came from. Remind the audience. I know you've been on before, but just bring us back up to speed. How do you all use leverage inside of the ETF? How does the actual sausage get made? Sure. On a bull fund, a leveraged bull fund, we'll look to either own a basket of the physical stock that the respective ETF index is tracking, and then what's called a swap on that index or ETF to provide the leverage.

4:50So that's just a derivative we use with a lot of the major banks to provide that daily leverage exposure. And then we have some cash on hand as well because of the margin to equity not requiring 100 cents on the dollar to get 300 cents of exposure, for example, on a 3x product. So there'll be some cash as well. On the short side or the bear side, we don't hold any physical. We just hold a swap on that respective index providing that leverage point. And there's also cash on hand as well. How does the interest rate environment impact the cost of that leverage? Because if you have a margin account somewhere, you're probably paying, I don't know, 8 % or 9 % right now to borrow against your portfolio and put it into something else.

5:36Do those higher rates trickle down into the swap rates and the options? How does that work? Yeah, I mean, without getting into the minutia, certainly the swap rates in terms of the borrow will be a little higher when interest rates are higher, but also the collateral will be receiving more as well for the cash on hand. So when you look at using these products, first of all, they're for short-term active traders, as we all know. And for most clients, if they want to get leveraged, they're going to have to utilize margin. With this type of structure as an ETF, you're getting that magnified exposure through the ETF wrapper.

6:15So I would say on average, it's probably more cost efficient to do it through a packaged ETF, even with a little bit of the higher cost for the swap, because you're getting a higher yield on the collateral or cash portion. And also, you don't have the unlimited liability in a packaged ETF. Your liability is limited to your initial investment. So for a lot of investors out there, it might be difficult to get margin. Also, the rates might be much higher at this point. Here's a way to get that leverage exposure in a packaged ETF, albeit they should know the risks associated with it. And on the short side, guys, it's even harder.

6:53You know, try to borrow stock or borrow a basket of stocks to short in terms of a lot of trading platforms may not even let you do that because of the unlimited liability. So here's a way to take a bearish leverage position or non-leveraged bearish position, again, with your liability being limited to the initial investment. And leverage can be used responsibly, but it could also be dangerous in the hands of people that don't know much about it. So let's not assume that listeners are well-versed in these products. I'm sure a lot of people that are listening right now have traded them and understand that these are not to be bought and held.

7:27But I assume you're talking to a new listener, somebody that's new and would like to use leverage and likes the structure and ease of getting in and out of these products. Can you talk about why these things should not necessarily be bought and held, why these are more active vehicles as opposed to buy and hold vehicles? Sure. First off, of course, the leverage magnifies the risk, whether you're taking a bullish or bearish position. So this is definitely for people that are not risk adverse, that want to take on risk. In terms of the trading vehicle and how it works, the timing matters when trading leverage and inverse.

8:04You need to know how the mechanisms of these work and the daily reset of leverage, which I think is key, because when you hold these for one day, it should track that underlying index with whatever leverage point for that given day. But after one day, there's going to be what's called compounding. That could work for or against you. And these are path dependent. So the timing and the trend matters when you hold these. So these are important for the clients to know that these are timing vehicles and your timing matters. Let me just give you a quick example. Let's say you have a triple leverage bull product and you have$100 to start.

8:45And the first day your underlying index is up 5%. So that means you made 15 % the first day. So your 100 goes to$115. But unfortunately, on the second day, that same index is down 5%, the underlying index. So you lost 15 % the second day. You're below$100 after two days. So that's a simple two-day example of compounding. You can't just add up the two days. I'm up 15 % one day. I'm down 15 % the next. I'm back to 100. because of compounding, you're actually down after two days. So you really need to know how these work before you should consider trading these. And the most important thing is the daily reset of leverage.

9:27And when you own these beyond one day and the timing and the path of that underlying index is imperative to whether or not that leverage could work for you or against you. I'm curious, how much of a trend do you see in the products? Obviously, there's times when certain things are hitting in times when they're not. In 2022, a year when bonds and stocks both got crushed, did you see a huge inflow into all the bearish products? Well, it's interesting. We saw a lot of inflows in bears, but we also saw some inflows in the bulls as well because of the fact that people were buying on the dip. Unfortunately, if you were trading for the most of the year, that buying on the dip mentality, depending on what we're talking about, didn't work.

10:12Now, as we move into 2023, we're seeing a lot of continued interest in the bear funds and some profit taking on the bull funds. But with that said, there's still some bull funds that have gotten a significant amount of inflows this year. So it really depends on the time period that you're referring to and where it's trending during that period of time to determine what our inflows or outflows would be. But just to give you an example of how these are being used correctly is all you have to do is look at the trading volume of our leverage and inverse ETFs on a given day. And you could have a situation where over the course of a couple of days, you could trade the assets of that ETF.

10:56And that's how they're designed for, for highly active trading and to monitor these on a day-to-day basis. Do you think that you would have any, Let's say that there was a really sophisticated AI model that was built around the flows coming into and out of your products. Do you think based on that alone, there would be any predictability on what the market might do in the short term? Or is this just a reflection of how the market performed over the last seven to ten days based on the underlying instruments? It's a good question. Some people look at the contrarian indicators. But when you look at our flows, for example, and our assets, on average, it's still a high propensity towards bull funds.

11:39I think people have less of a propensity to short by nature. As a result of that, we're always skewed towards the bull side in terms of when you look at our total assets. But with that said, there are periods of time where we see significant inflows in bear funds, either to protect short-term gains or an outright short that they want to initiate. For example, NVIDIA this month, we just launched the one and a half times bull non-leverage inverse bear on NVIDIA. Now, it's up 200 % roughly for the year, give or take what's happening today. Yet this month, NVIDIA is down 12%. So the timing matters.

12:16So you could have a one and a half times bull. That's really worked out well for you in NVIDIA. But at the same time, if you timed it properly this month, you know, if you were short, NVIDIA, non-leverage inverse short, you made money. So it really depends. But I think the best example of showing why these are not long-term holds is you look at yin and yang this year, for example. That's the triple leverage. Some people might be familiar with the China FTSE 50 or FXI, which is the non-leveraged version. We have a triple leverage bull and bear, yin and yang, on that China FTSE 50. Both the bull and bear are down this year.

12:54Why? Because there's been volatility in both directions. and there tends to be decay when that happens. If you hold the leverage products for long periods of time, if there's a lot of volatility and no directional or discernible one-way movement. So you could have nailed the macro on this and said, we think Chinese stocks are still going to get crushed because of all the stuff that they're going through. But if you put this trade on, this bear times three, the Yang fund, and held onto it, you'd have lost money. Correct. It's a great lesson. Yeah. I mean, same thing with regional banks. That's another one.

13:30We have a triple leverage bull on the regional banks, DPST. If you timed it right and owned it in the month of March, you would have got crushed. You would have lost over 60 % in DPST because the regional banks, which it tracks, had a horrific downward month and some unfortunate bankruptcies there. But if you look at July and timed it properly, the month of July, regional banks really had a strong month. And DPST, which is the triple leverage, was up over 60%. So when I mentioned the timing matters, these are timing vehicles. They're not to be held indefinitely. Ben, Ben, this isn't for you. It's for people like me.

14:08It's for people like me. Well, my follow-up here is we get questions all the time from people who say, listen, I'm in my 20s or 30s. I have 30 or 40 years ahead of me to save. Why couldn't I just put my money, and I understand the volatility is going to be way higher. Why couldn't I just put my money into two times S &P 500 and then I'll be fine. Are any of these products going to buy and hold? Ben goes two times. You need five times. But are there any of them that can be okay to buy and hold? Are they all just because of the reset and the volatility, you're really setting yourself up for danger potentially?

14:37Well, certainly two and three X for sure. We have the one and a half on the single stocks. So if you were going to use it like some financial professionals do as what's called portable alpha, what does that mean in English? Basically using the leverage to free up capital within the portfolio and putting in other asset classes like non-correlated asset classes. So for example, if you have a one and a half times product like on NVIDIA and you want to not put 100 cents on the dollar in NVIDIA, you could take two thirds to get 100 cents on the dollar and take that other third and put it in other types of investments to diversify the portfolio.

15:14The one caveat there is you have to rebalance to keep that ratio intact. But you've got to monitor that still day-to-day, week-to-week on that. But the lower the leverage point, there's going to be less of the compounding impact. So you could make the case of maybe holding it, but you've still got to monitor it day-to-day, and there's going to be compounding regardless of the leverage point. Now, a non-leveraged inverse like our SPDN, we have a lot of individuals that are holding that longer, knowing that the K is going to be nominal because it's a non-leveraged inverse on the S &P 500. still have to monitor it day to day.

15:50But some individuals are using that in the portfolio as maybe a hedge or to reduce their large cap beta in the US. So it's a way to reduce beta or to take it outright short trade. And if you're wrong, you could be less wrong. So the financial professionals, though, are going in and out of these 2 and 3x products the same way as sophisticated retail. These are trading vehicles. And if you're hedging with 2 and 3x, you got to realize that these are short-term ways to hedge. Ed, what's the ticker for the two-time levered industrial ETF? We don't have it two times. We have it three times. What's the ticker?

16:30DUSL. I was just testing you. Man, you're good. How many tickers do you have in your brain? A lot. I've been here 12 years, so I can rattle them off all day, but nobody wants to hear that. Are you ready for an industrial trade, Michael? No, I was just testing him. Credit to Ed. All right. So I would guess that people that are using leverage are more likely to be trend followers than they are trying to catch the bottom. In other words, if the stock market's going up, they're more likely to buy leverage on the bull as opposed to saying, no, no, no, no. This is the top. I'm going to leverage the bear.

17:04Conversely, if the stock is going down, I'm guessing that they're probably going to be shorting as opposed to catching the bottom and going the other way. I know there's probably exceptions all over the place. Would you say, is that generally true or do you not see it that way? No, we see a lot of contrarian flow in terms of when something is rallying, we tend to see being used properly and selling on those rallies and possibly buying the bear funds. So it really depends. The technical trend follower, the short-term trend follower may act in that regard because they're using technicals. But don't forget, a lot of people look at headlines and macro events too and trade off of that.

17:42So that's good and technicals as well. So when we look at a lot of money managers, hedge funds are utilizing our products within their strategies, but as short term trading vehicles. I don't know if there is even is like an average for an ETF, because obviously it all depends on how people use them. But how much more would you say that your funds turn over than the regular buy and hold ETF? Well, let's put it this way. We could have a couple of billion dollar fund, for example, that can turn over in three, four days or even sooner, depending on the index. So it's a lot different than owning SOX versus SOX L or SOX S, which are triple leverage bull and bear semiconductors.

18:27So they should be used differently. But let's not delude ourselves. semiconductors has a high beta. There's risk to SOX. It's just that that is a non-leveraged vehicle and it's part of an overall diversification within the equity portfolio. And you might want to have something specific to semis in addition to the broad indices that provide that exposure to you as well. So if you see$3 billion in some double or triple bull or bear fund, that's not like static$3 billion. That whole$3 billion could be bought and sold within a week or so. Yeah, but on average, you got to look at the assets as a whole.

19:03And the assets are going to fluctuate in our broader suite of leverage and inverse different with our thematics. So we're used to that. And the underlying instruments we're using, we want to make sure that that market is orderly, that the spreads are tight, and that people could trade in and out of these things freely. Keep in mind, everything we're doing in the leverage and inverse space is tracking either an equity index or a fixed income index like the 20 plus year treasury or seven to 10 year treasury or a single stock. So everything that we're trading is on an underlying exchange. There is no derivative of a derivative.

19:39Let's say that. So there's no leverage on something that's not on the equity exchanges or a fixed income. I think something we've never asked you before, Or how big and nimble is your trading team? Because I imagine you have to be pretty versed in a lot of different markets and different strategies and securities. Because you could have a fund that has$10 million in it. And something happens and blows up or goes crazy. And you could have a billion dollars in a couple months in it. So how does the trading team handle stuff like that? Well, it's all about the underlying. As I mentioned in the beginning, it's what that underlying index is tracking, how we're getting exposure to it.

20:18So since we're using equity benchmarks, fixed income benchmarks, it's really all about the underlying liquidity and making sure we can get that exposure on a day-to-day basis. So that's the key. In terms of getting underlying exposure to most of these indices, they're very liquid. So either we'll use a physical ETF in a lot of our international leverage and inverse and a swap on that ETF or a basket of stocks and a swap on the index. So it's all about the underlying. And keep in mind also, the counterparties are providing that swap exposure. We just got to manage that exposure on a day-to-day basis.

20:54So we reset the leverage back to 3x every day. What about for something like commodities where it's not obviously a stock index? Well, it's different. We don't have any leverage or inverse physical commodities. Everything that we do in the commodity space is commodity-related equities. So for example, we have leverage and inverse exposure on the Energy Select Sector Index, which of course is a basket of stocks. Chevron and Exxon lead the way there. And we also have it on the S &P Oil Gas Exploration and Production Index. So those are all baskets of stocks. Same thing with the gold miners and junior gold miners, two ex-bullet bears there.

21:33The only thing we have in the physical commodity space is non-leverage. So if you wanted a pure commodity play that was more as a part of a diversification of an overall portfolio. We have our comm ETF that could be utilized more as strategic asset allocation for clients to diversify their equity and bond exposure. If they feel inflation is going to stay, you would want to own a broad basket of commodities. The one distinction with our product versus maybe the Goldman Sachs Commodity Index, or the Bloomberg Commodity Index, which are good proxies for the broader commodity space, but they're static long only, and you really can't hold those indefinitely.

22:11You got to be sort of tactical with it. Our strategy actually will be longer in cash based on price trends, and it's completely rules-based. We licensed an index from a CTA, Commodity Trading Advisor, Auspice Capital. It's been out there for many years, the index. The ETF's been over six years, but one of the distinctions is it won't be static 100 % long. Right now, we're long six out of the 12 commodities. It's not because I woke up in the morning and decided to do it. It's because of price trends that we're tracking that index. So we're long crude oil, heating oil, and gasoline. That wasn't the case at the beginning of the year.

22:48And as you guys know, there's been a tremendous rally in energy stocks in the third quarter and along with crude oil. And although they're not directly related, I'm sure the increase in crude oil prices has definitely been a tailwind for energy stocks. And you're seeing that. Is that an equal weighted index then with the commodities or are they weighted close to some benchmark? It's equal weighted based on risk. So when the position's put on, it'll size the position based on its current volatility, but it equal weights on risk. So on average, a commodity will receive anywhere from 7 % to 15%, depending on that underlying commodity risk level when the position's put on.

23:28So it's sort of a risk parity in that regard. That's more of a buy and hold approach to commodity investing. It tries to capture the majority of the commodity upside, but also try to mitigate the downside risk that's often associated with broad commodity benchmarks because commodities are very volatile and can be, both to the up and downside. Now, I know Direction has a wide suite of products, but the market, and when I say the market, I'm talking about the S &P 500 has been fairly boring this year. The VIX has been sub-15 for a few days or weeks. Do people overtrade in boring markets, or is there more likely to be activity in your leveraged products when the VIX is, say, at 20 or 25?

24:08Well, I think volatility always helps. But also, if you have low vol and a trending, stair-stepping-up market, which is, for the most part, what we've had this year, that that provides opportunity as well. So if it's volatility that is extreme and is fluctuating and doesn't have a discernible direction, that could be a difficult market for traders. But this year, even though the vol has been low, you know, the market's mostly stair stepped up. But with that said, there are opportunities on the short side if you time it well. Also, look at China this year, underperformed the US market the last couple of years, very volatile this year.