FAS ETF Is A Buy On Rising Interest Rates

Thesis

The Direxion Daily Financial Bull 3x Shares (NYSEARCA:FAS) seeks daily investment results of 300% of the performance of the Russell 1000 Financials Index. The Russell 1000 Financials Index (RGUSFLA) is a subset of the Russell 1000 that measures the performance of the securities classified in the financial services sector of the large-capitalization U.S. equity market. A retail investor cannot directly invest in an index. As the Fed is set to raise rates at least four times in 2022, Financials have benefited, making them a top sector pick at UBS for 2022. With a historic rotation from Growth to Value unfolding before our eyes as rates normalize, the Financials sector is a good pick for a rising rates cycle. FAS, due to its leveraged nature, is not a buy-and-hold vehicle for a retail investor. Think of FAS as more of a surf-board that can currently be utilized to ride out a 2022 that will see a substantial hike in the Fed risk free rates and a historic move from Growth to Value. In the past year, FAS has indeed posted an eye-watering 100%+ return, but a savvy investor needs to keep in mind that the Covid-19 drawdown was -75% for this fund. We like financials for 2022 and we like the FAS set-up. We rate it a Buy on the current market weakness with a 25% target return. For avoidance of doubt we do not see FAS as a buy and hold fund but as a tool to be utilized for 2022 only with a short trading time frame in mind for the chosen target (i.e. sub 1-year).

Interest Rates and Financials

We have now entered a tightening interest rate cycle where the Fed is set to finally raise rates from historic lows:

Financials are set to benefit from a rising interest rate environment. Let us take a commercial bank as an example – the institution in its purest business model form borrows money from consumers via deposits and lends to business and other individuals via loans and credit cards. As rates rise, said bank is able to increase the rate / yield it charges on its loans while at the same time it benefits from the flexibility of not raising rates for the consumers’ deposit. The net profit it makes from lending versus what it pays on deposits is called net interest margin. Net interest margins usually expand as a central bank raises rates, thus improving the profitability of financial institutions.

Higher rates also translate into higher profitability for more complex financial institutions like investment banks and brokerage companies via various mechanism such as margin loans charged, transaction profitability and cash management fees for institutional transactions. Investment banks which usually cater to the institutional investors cohort are usually large holders of cash for said institutional investors. When rates are low the investment banks do not make any yield on said holdings but have capital requirements around them. When rates go up the bank now suddenly makes a return on cash which it does not always pass to the customer / institutional investor. The tremendous amount of liquidity and cash available in the financial system as a result of low rates can be observed in the shocking figure of Overnight Reverse Repurchase Agreements balance that has ballooned after Covid:

Holdings

The Russell 1000 Index measures the performance of the large-cap segment of the US equity universe. The Russell 1000 Financial Services Index measures the performance of companies in the Russell 1000 Index that are involved in banking, mortgage finance, consumer finance, specialized finance, investment banking and brokerage, asset management and custody, corporate lending, insurance, financial investments and real estate. The current Index top holdings are:

The Index top ten holdings currently constitute more than 47% of the holdings weightings. The Index is currently tilted towards banks, with an allocation above 36% for this subsector:

Performance

On a 1-year lookback period the ETF has had a strong performance of 108%:

In 2022 FAS was already up more than 16% before the recent market sell-off:

A retail investor should make no mistake in thinking this is a buy and hold vehicle. It is not. FAS is currently riding the cyclical trade that favors Financials in a rising interest rate environment. When the macro cycle turns to a recession and a bear market, FAS can lose value with a shocking velocity:

During the Covid market meltdown, FAS had a -75% drawdown. Any financial instrument exceeding a -50% drawdown is not a buy and hold security in our minds, and a retail investor should be very careful in navigating the macro cyclical environment when holding such financial instruments in their portfolios.

Conclusion

A leveraged instrument FAS is not a buy and hold fund but rather a cyclical “surf-board” that can be used by a savvy investor in the economic cycle. We are now entering a rates tightening environment which is set to benefit financials via increased profits from net interest margins. While the current market swoon might persist a little longer, a savvy investor can pick a good entry point in FAS. We rate FAS a Buy with a 25% target return.