Do Europeans Want Leverage?

Direxion’s move into Europe, announced yesterday, brings one of the fastest-growing firms in the US ETF market to this side of the Atlantic.

They also operate within the most controversial sector: leveraged ETFs. Things have quietened down a bit since the furore over leveraged fund returns a year ago that led to a spate of lawsuits in the US. Whatever the merits of these legal cases (and I can’t see many, given that fund prospectuses and marketing materials clearly specify that leveraged ETFs deliver their performance based on a multiple of daily, rather than period returns), it’s clear that the controversy has had some effect on the growth of this sector.

A year ago, according to NSX data, leveraged ETFs represented 5.3% of the US market by assets under management, but that market share has now dropped to 3.6%.

Direxion has continued to grow its own business, however, with its assets under management increasing from US$1.8 billion to US$5.2 billion over the same period. With its funds charging 0.94% in fees, that’s a healthy US$50 million or so in cash flow each year.

Ironically, the SEC’s recent decision to review the use of derivatives in mutual funds and ETFs has reinforced the competitive position of Direxion and its main competitor, ProShares, since for the time being there’s a block on new ETF launches of this type, while existing funds can continue to operate.

Given the regulatory uncertainty in the US, though, it’s perhaps unsurprising that Direxion is diversifying internationally and, in particular, making use of the facility to cross-list in Europe via the Dutch regulator’s “fast path” route (a way to sell US-registered funds).

In fact, Europe’s UCITS rules would not have allowed a Direxion-type structure to be set up (had the provider wished to replicate it over here rather than cross-listing), since the regulations allow a maximum of 200% leverage (either long or short), while Direxion’s ETFs offer plus or minus three times the daily index return.

But will the company find success on this side of the Atlantic? I’m sceptical, for two reasons.

First, there’s evidence that European ETF investors do not want as much leverage as their US counterparts. Leveraged ETF assets are a mere 2% of the European market, compared to nearly double that in the States. Less geared, simple inverse ETFs (offering minus one times the index return on a daily basis) are, however, more popular in Europe than in the US. Why? Because there’s a large day trader culture in the US using leveraged ETFs, which is mostly absent in Europe. Those US traders like gearing, and lots of it. However, institutions and hedge funds (the type of clients Direxion says it is targeting over here) can achieve leveraged and short exposure in other, more efficient ways.

More importantly, though, I think the evidence shows that to sell ETFs in Europe you need a real business presence: website, marketing, sales and trading support in the languages of the countries you’re targeting, the lot. I know I’ve just written that Direxion is unable to reconstitute its ETFs within Europe for regulatory reasons and can only sell its US funds. But I think that without the local presence it may struggle to raise significant assets.

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