Summary Since inception, the ETF has depreciated over 98%. Its long run expected value is zero due to the structural deficiencies of leveraged ETFs, combined with the positive expected return of emerging market equities. The ETF is easy to borrow, making this an actionable short candidate when sized prudently. Background on the Fund The Direxion Daily Emerging Markets Bear 3X ETF (NYSE: EDZ ) seeks daily investment results, before fees and expenses, of 300% of the inverse of the performance of the MSCI Emerging Markets Index. As summarized below, the MSCI Emerging Markets Index is diversified geographically across 23 countries and 837 individual stocks. Source: MSCI Emerging Markets Index Fact Sheet The Direxion fund attempts to create its leveraged exposure through investing at least 80% of its assets in a combination of instruments/derivatives including futures, options, indices, swaps, forwards, reverse repurchase agreements, ETFs, and equity caps, floors and collars. As shown below, the fund is down more than 98% since its inception in late 2008. (click to enlarge) In order to understand the reasons for this performance, as well as whether it’s likely to persist over the long run, it helps to break down the performance into its two key drivers: 1) the return of the underlying index, and 2) the construction of the ETF. Let’s go through each. Performance of Underlying Index Despite the recent turbulence in emerging markets, the MSCI Emerging Markets Index is up just over 8.5% annually since 2000. (click to enlarge) Source: MSCI Emerging Markets Index Fact Sheet As we look forward, predicting short term moves in the market is extremely difficult (or impossible, according to some academics). But we do know that the MSCI EM Index is trading at an average (12 month forward consensus) P/E ratio of about 11, which translates to an earnings yield of about 9% (higher if cyclically adjusted). This means that if we ignore growth and assume that valuation multiples stay constant, the annual return of the index would be in the very high single digits so long as the value created by the underlying companies ultimately accretes to shareholders. (click to enlarge) Source: Yardeni Research Global Index Briefing Construction of ETF The second (and likely more important) driver of returns for the Direxion ETF over longer periods of time is the methodology of its construction. There are numerous articles in the academic literature (such as this ) reviewing the tendency of leveraged ETFs to decay over time. I’ll go through a number of additional examples of this decay a little later on, but first let’s walk through the reasons why it occurs. Effectively short volatility / mean reversion: Since the ETF seeks to track the daily returns of the underlying index, it must rebalance on a daily basis. When the index goes down, the ETF must add short exposure to maintain its positioning, and vice versa when the index goes up. In other words, the ETF routinely needs to “buy high and sell low.” The result is that in volatile, but non-trending markets, the ETF decays. The fund’s prospectus provides an example that “this fund… would be expected to lose 31.3%… if its Index provided no return over a one year period during which the Index experienced annualized volatility of 25%.” Magnified transactions costs: ETFs incur transactions costs when investors move in and out of the funds. The impact of this can be magnified for leveraged ETFs like EDZ since a) a large portion of the underlying investors in these funds are short-term oriented, and b) the funds must rebalance daily based on market moves, as discussed above. Fund expenses: Though not unique to leveraged ETFs, fund expenses are another marginal drag on returns. Per the fund’s prospectus, its operating expense ratio is approximately 0.98%. Additional Examples Below we can see a summary of annualized returns for the various equity-related Direxion 3x leveraged ETF pairs that have track records of at least 2 years. Name Ticker Appx Annualized Return since Inception Daily Energy Bull 3x ERX 0% Daily Energy Bear 3x ERY -47% Daily Financial Bull 3x FAS 14% Daily Financial Bear 3x FAZ -68% Daily Gold Miners Index Bull 3x NUGT -70% Daily Gold Miners Index Bear 3x DUST -12% Daily Junior Gold Miners Index Bull 3x JNUG -81% Daily Junior Gold Miners Index Bear 3x JDST -71% Daily Real Estate Bull 3x DRN 45% Daily Real Estate Bear 3x DRV -59% Daily Semiconductor Bull 3x SOXL 19% Daily Semiconductor Bear 3x SOXS -53% Daily Technology Bull 3x TECL 38% Daily Technology Bear 3x TECS -53% Daily Mid Cap Bull 3x MIDU 25% Daily Mid Cap Bear 3x MIDZ -53% Daily Small Cap Bull 3x TNA 30% Daily Small Cap Bear 3x TZA -60% Daily FTSE China Bull 3x YINN -8% Daily FTSE China Bear 3x YANG -42% Daily Developed Markets Bull 3x DZK 1% Daily Developed Markets Bear 3x DPK -43% Daily Emerging Markets Bull 3x EDC -6% Daily Emerging Markets Bear 3x EDZ -47% Daily Russia Bull 3x RUSL -58% Daily Russia Bear 3x RUSS -30% Simple Average -27% Although all of these ETFs are vulnerable to the sources of decay outlined above, in this article I highlight the Direxion Daily Emerging Markets Bear 3X ETF for a few important reasons: This ETF is easy to borrow (with a cost under 3% through some retail brokers), which makes it worthy of consideration as a longer term short for those knowledgeable in these products. However, a critical caveat is that the position would need to be sized prudently, given that there have been occasions when some of these ETFs have moved more than 100% over relatively short periods of time. Emerging market equities are an especially volatile asset class, which I expect to exacerbate the leverage trap given that these ETFs tend to underperform during periods of volatility, as discussed above. Equities tend to be more mean-reverting (compared to commodities, which often trend). As again reviewed above, these ETFs tend to decay most in mean-reverting environments. Emerging market equities are likely to have one of the highest long run expected returns among asset classes (though not necessarily the highest Sharpe) given their elevated earnings yield noted previously. Conclusion As long as one believes that the long run performance of emerging market equities will be positive or that it will be flat but with non-zero volatility, the long run expected value of this ETF is zero. Those considering trading the ETF should be cognizant of this (and the implicit bet on volatility that they are making).