The more risk you can assume and endure, the greater the reward, according to modern investment theory.
But there is more to the theory. Price matters. Indeed, price might matter more than anything.
No investment is inherently more or less risky. Risk rises or falls depending on the price paid. A stock that trades at 50 times earnings whose share price has increased 10 times in 10 years is generally speaking riskier (more at risk of a systemic selloff) than a stock trading at 10 times earnings whose price has doubled in 10 years.
Sentiment changes. What’s favored today will be shunned tomorrow, and vice versa. Anyone who owns large-cap tech stocks will attest to my assertion – favored yesterday, out of favor today.
It works the other way, too. Stocks that are out of favor today return to favor tomorrow.
Few sectors have fallen out of favor with investors more than biotech. The SPDR S&P Biotech ETF (NYSEArca: XBI), an exchanged-traded fund of 135 biotech stocks, is down 46% from its 52-week high. I can’t say that I’m surprised when I see that six of the ETF’s top-10 holdings are down 50% or more. Three are down 70% or more.
SPDR S&P Biotech ETF: 12 Months of Pain
Nevertheless, many of these companies successfully run the regulatory course to bring valuable, patent-protected therapies to market. Many also find themselves the targets of the larger pharma giants. [GlaxoSmithKline’s (NYSE: GKS) recently agreed to pay $1.9 billion to buy Sierra Oncology (NASDAQ: SRRA).]
But few investors care today. Biotech has fallen so far out of favor that investors are bestowing many with a negative enterprise value, meaning that their market caps are less than their cash balances. Investment bank Jefferies recently identified 31 listed biotech companies with a market cap above $100 million that are trading at a negative enterprise value.
The biotech selloff has been prompted by a confluence of factors. For one, investors are seeking safer assets as central banks raise interest rates to fight soaring inflation. Others have concluded that biotech stocks became overvalued at the peak of the pandemic.
The biotech sector has always been plagued by volatility. For that reason, I have never considered the S&P Biotech ETF (XBI) to be an investment. I perceive it as a trade, particularly when sentiment is most negative, as it was in 2009, 2016, 2019, 2020, and is today.
SPDR S&P Biotech ETF: Price History
The S&P Biotech ETF (XBI) is a contrarian investment, to be sure, but it’s not where I want to go.
The opportunity to make more money – a lot more – resides in a derivative investment to the S&P Biotech ETF (XBI). I refer to the Direxion Daily S&P Biotech Bull 3X Shares ETF (NASDAQ: LABU).
The Direxion ETF tracks the S&P Biotech ETF (XBI), but with a twist. The Direxion ETF will move three times what the S&P Biotech ETF moves. The S&P Biotech ETF rises 2%, the Direxion ETF will rise 6%. The S&P Biotech ETF falls 2%, the Direxion ETF falls 6%. The Direxion amplifies the moves with swaps, futures, and other derivative instruments.
The chart below reveals why the Direxion ETF is also a trade as opposed to an investment. The shares traded up to $220 when the fund was introduced in June 2016. The shares traded at $20 nine months later. They traded at $180 during the first quarter of 2021. They trade near $6.50 today.
The Direxion ETF shares trade today at lows unseen in the fund’s six-year history.
The Direxion Daily S&P Biotech Bull 3X Shares ETF’s Wild Ride
The Principal Objection
It’s volatility decay.
The detractors of leveraged ETFs, of which the Direxion ETF is one, site volatility decay as the primary reason to avoid leveraged ETFs.
The detractors have a point. Volatility decay refers to the value lost through price volatility that occurs when the share price is either flatlining (non-trending) or trending lower.
If the share price is up 5% one day and then down 5% the next, and the percentage movements alternate as such daily over enough time, the share price will approach zero. Even if the share price had been flatlining, the volatility decay will erode value to send the price lower. An ETF that leverages the volatility, as the Direxion 3X ETF does, will hasten the decay. Indeed, the S&P Biotech ETF (XBI) dropped from $170 in early 2021 to $72 today. The Direxion 3X ETF (LABU) dropped from $180 to $6.50.
So, yes, volatility decay is a legitimate concern.
On the other hand, volatility is a benefit when the share price trends higher.
After the COVID-induced selloff in early 2020, stocks trended mostly higher through the remainder of the year. The S&P Biotech ETF shares rose from $65 to $170 over the ensuing 10 months. The Direxion 3X ETF shares rose from $20 to $180 over the same period. The S&P Biotech ETF gained 162%. The Direxion 3X ETF gained 800%.
Leverage is a momentum builder for stocks trending higher.
Not for Everyone
The ability to endure volatility is essential. Daily price movements of 15% – up or down – are not uncommon.
Equanimity is another requisite character trait. If you are unable to operate on an even keel, the Direxion 3X ETF is not for you. To become manic over a 15% advance only to become depressed at a 15% decline is to render yourself miserable.
The Direxion 3X ETF trade is a side hustle. It’s NOT the primary portfolio investment. I would consider allocating no more than 5% of my portfolio to a leveraged investment.
With that said, I like the Direxion Daily S&P Biotech Bull 3X Shares ETF. I think the opportunity to earn 10X over the next 12-to-24 months is legitimate. That would mean the share price goes from $6.50 to $65.00. The price chart above suggests such a price movement isn’t preposterous.
Will the Direxion Daily S&P Biotech Bull 3X Shares ETF be trading at $12 or at $2 at the end of July? Neither price would surprise me.
Longer-term, I think a much higher price will prevail. After all, biotech stocks are value-priced to the extreme today. From extreme value comes the exceptional opportunities to enhance wealth.