Risk has a range. From cash to the most exotic products on the planet, investors can and do choose to dial it up or down. But sometimes investors miss the degree of risks and perceive something to be safer than it actually is. Direxion Technology Bull 3x Shares (TECL) is one such fund that is designed for 90% plus downside over the next decade. We explain why below.

The Fund

TECL invests in the technology sector and tries to mimic 3X daily returns of the Technology Select Sector Index (IXTTR). This index is brought to you by the S&P Dow Jones Indices and includes domestic companies from the technology sector, which includes the following industries: computers and peripherals; software; diversified telecommunications services; communications equipment; semiconductors and semiconductor equipment; internet software and services; IT services; electronic equipment, instruments and components; wireless telecommunication services; and office electronics. The Fund has a huge concentration in the software industry, and the top 4 components make up 50% of the Fund.

Source: Direxion

The Fund achieves its 300% leverage by using swaps.

Source: Direxion

The 3X daily leverage has proved amazing in this bull market, and the returns here have been just mind-boggling.

Source: Direxion

46% compounded since inception with no 2-20 structure? Have investors found the Nirvana in investing? We tell you why things worked and why this Fund will go down 90% from here over the next decade. Three factors will play a role.

Why Did The Fund Succeed?

The Fund was founded in December 2008. While the major indices had bottomed in March 2009, a vast majority of stocks had already bottomed by October 2008. Valuations were incredible in the technology sector. Microsoft (MSFT), Apple (AAPL) and Intel (INTC) were trading around 5X EV to EBITDAs.

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ChartData by YCharts

Thus, a bull was born on maximum pessimism. Nobody thought we would ever need another Office software again, and people thought Apple’s peak days were behind it. But that is the past, and we think the next 12 years will be decidedly different. We go over three reasons why this Fund will go down by 90% over the next decade.

1) Valuation

Valuation measures for its top holdings are stretched, and that is putting it mildly. While INTC appears cheaper amongst the 3, and certainly one we would be most “neutral” on, that is largely as competitive pressures from its rival, Advanced Micro Devices (AMD), are likely to keep margins moving lower.

ChartData by YCharts

As a reminder, the S&P 500 peaked at the peak of the dotcom bubble at about 14X.

Valuation has historically accounted for the bulk of the forward returns over the next decade.

Source: Neal Falkenberry, Twitter, June 30

That shows the S&P as a whole and the expected total return is negative. While that may seem negative, the technology sector as a whole is trading at over 18X EV to EBITDA levels. So, paying such huge premiums for companies which can never achieve past growth rates will be extremely punitive.

2) Returning To Normal Weighting

Sectors change and evolve over time. Nothing cures high margins like high margins. As gross margins jump up, we see new entrants in the market. What also helps them is the market’s love affair with the sector. New entrants are able to raise capital at outrageous valuations, and this gives them a war chest to take on the incumbents. Hence, we see charts like this.

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Today, technology, alongside healthcare and consumer discretionary sectors, has moved close to the 2000 peak. That will change over time and take a heavy toll on this ETF.

3) Leverage

3X funds are fine when things are going up, but when they hit the sideways trend, this get less enjoyable. What we expect more than anything else is a decade of multiple rallies and declines as valuations compress back to normal. This should play exceptionally well to increase the decay built in to these funds. Since the Fund is based on daily returns, every day, you are more invested if it goes up and less invested if it goes down. This works very well in bull markets, but wrecks havoc in sideways to down markets.

But, Surely, We Jest About The 90%?

We can illustrate what we expect by showing you a chart of GDX from 2014 till March 23, 2020. The ETF was flat over that time but suffered from incredible volatility. It had some breathtaking rallies and heart-stopping declines. You can see the Direxion Daily Gold Miners 3X levered Fund (recently changed to 2X) (NUGT) underperformed the index by more than 100%.Chart

Data by YCharts

While we do expect volatility in technology shares to be muted compared to gold miners, remember that we are making our outlook over a longer time frame.

Conclusion

TECL has leverage packed to the maximum. The companies comprising it were delivering what are likely their peak margins on a trailing 12-month basis. Those peak margins are leveraged by large multiples. The whole thing is rolled into a 3X leveraged fund. 44% compounded returns over the last 12 years is no joke, and investors sitting on piles of returns should consider exiting this. Even if you are bullish on the sector, 3X leverage with these valuations is Ghost Pepper level of heat. Sophisticated investors may find ways to borrow and short this as a downside hedge in today’s market.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in TECL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.



Via SeekingAlpha.com