Bearish China ETF Fades a Year After Rout Pushed It Over the Top

(Bloomberg) -- An exchange-traded fund designed to profit from declines in Chinese stocks that was a standout when it was created a year ago is now languishing as the country’s growth outlook improves.

Total assets in the Direxion ETF surged 101 times to $403 million from June to August 2015 as traders piled in to take advantage of a market selloff. Now they’ve shrunk to less than $90 million as the leveraged fund’s shares trade near a record low.

The Direxion Daily CSI 300 China A Share Bear 1X Shares fund, the fastest-growing new ETF when it was started last year, has dropped 24 percent from this year’s high in February. Better than expected economic data and government efforts to enhance market transparency have helped drive a rebound in mainland-traded stocks from the lowest levels in two years.

“When it comes to a leveraged fund, one day you can be the best-performing product when the market is cooperating, and the next day you are crashed,” Mohit Bajaj, a director of ETF trading solutions at WallachBeth Capital in New York who has been covering exchange-traded funds for more than 10 years, said by phone from New York. “We may see the fund rally again once the sentiment on China sours, but it’s easy to make a mistake and lose a lot of money.”

The quick success of the Direxion ETF, the first designed to use leverage to amplify returns from falling Chinese mainland shares, was partly because of the right timing. It started just prior to a market crash spurred by a surprise yuan devaluation. For some bears, it was easier to buy the fund than use the two other main options available at the time -- the futures market or short-selling the Deutsche X-trackers Harvest CSI 300 China A-Shares ETF.

A year ago, when the China market rout was at its worst, the Direxion fund’s assets swelled at the fastest pace among the almost 200 U.S.-traded ETFs that started in the prior eight months, according to data compiled by Bloomberg.

After about $5 trillion of equity value was wiped out in the rout last year, China has moved to improve access to markets and stabilize a slowdown in economic growth. The nation’s economic expansion held at 6.7 percent in the second quarter from a year earlier, beating the 6.6 percent growth forecast in a Bloomberg survey.

‘Amplified Returns’

“If we see a pullback in China, I would expect that the assets in the bear fund would creep back up again,” Sylvia Jablonski, managing director at Direxion Investments, said by phone last week. “We never recommend holding our ETFs for a long period of time, at least not without actively managing and reviewing your position on a daily basis.”

Leveraged ETFs use swaps or derivatives to try to amplify daily index returns, delivering the multiple on a one-day return. This ultimately can produce higher-than-expected gains if the index moves in one direction over the long term. Market reversals will lead to worse-than-anticipated returns.

Laurence Fink, who oversees the world’s biggest suite of ETFs as chairman of BlackRock Inc., has sharply criticized the leveraged structure, saying such funds could “blow up the market.” Regulators are paying close attention, particularly after finding ETFs were partly responsible for a bout of market mayhem last year.

For the brave of heart, leveraged funds could bring some hefty returns. Four of the top five U.S. ETF performers this year are leveraged funds. The best-performing fund this year, Direxion Daily Junior Gold Miners Index Bull 3x Shares, has rallied 920 percent this year through Thursday.

Some exchange-traded fund analysts remain cautious.

“The level of risk that the leveraged funds have is too much for some of the traditional ETF investors to put up with,” Todd Rosenbluth, a New York-based director of ETF research at S&P Global Market Intelligence, said by phone last week. “Leveraged funds are for some highly sophisticated traders, but even so the risk is too high you can lose all you got.”

--With assistance from Ye Xie To contact the reporter on this story: Elena Popina in New York at epopina@bloomberg.net. To contact the editors responsible for this story: Nikolaj Gammeltoft at ngammeltoft@bloomberg.net, Richard Richtmyer