Banking Crisis 2.0? The "Contagion" ETF That Gains 3% for Every 1% Banks Drop

Lost in the commotion of the Global Financial Crisis was the fact that, back then, exchange-traded funds (ETFs) were young. They still are in financial market terms, but in 2008, the State Street SPDR® S&P 500 ETF Trust, which was the first ETF to trade in U.S., was just 15 years old.

Yet even with that relative youth, one of the "stars" of the crisis was an ETF: The Direxion Daily Financial Bear 3X Shares (NYSEMKT: FAZ). That fund and its bullish counterpart, the Direxion Daily Financial Bull 3X Shares (NYSEMKT: FAS), rose to prominence during the crisis, to the point that they were bandied about in mainstream financial media by their tickers alone.

This famous ETF is a contrarian bet against the financial services sector. Image source: Getty Images.

That stardom happened even though those leveraged ETFs debuted in November 2008, at the tail end of the worst crisis-induced market conditions. Indeed, the Direxion inverse ETF was a shooting star, more than doubling in value in the first three weeks on the market.

With FAZ, history matters

"Shooting star" is an appropriate way to describe this ETF because, as we learned in middle school science class, shooting stars ultimately burn out. The bearish financial services ETF did so too, closing 2008 with a 50% loss.

That's why I'm dredging up ancient history here. It's a reminder that geared ETFs do what they're supposed to do over the course of a day or a few days, but holding these products for weeks or months on end is highly risky and potentially ruinous.

As for what this Direxion ETF is supposed to do, it aims to deliver 300% of the daily inverse performance of the S&P Financial Select Sector index, a basket of financial services companies in the S&P 500. One way of looking at this inverse ETF is that it's an interesting idea for traders who don't want to short individual stocks directly and for those with bearish views on financial services, while avoiding the homework of finding the best short candidates.

That's fine, as long as end users remember that leveraged ETFs are trades, not long-term instruments. The reason for this is that issuers of these products, including Direxion, rebalance these ETFs daily using swaps to accomplish that objective. Due to daily resets, a product like this bearish Direxion fund is likely to behave as expected over a day or a few days.

Still, when holding periods extend to weeks or months, the results can deviate wildly from the underlying index. Traders who don't acknowledge the daily resets can turn into bag holders, and that's never fun.

For traders, this ETF has value

The Direxion Daily Financial Bear 3X Shares is obviously a contrarian bet against financial stocks. For that wager to pay off, bank and insurance stocks must decline. The trick is figuring out when that's going to happen. That leads into how to use an ETF like this one. One use case is for ultra-temporary protection of long positions in financial stocks.

Additionally, the inverse fund could be profitable during bank earnings season, provided the updates are disappointing, or if the Federal Reserve does something unexpected, in a bad way, with interest rates. Bottom line: This Direxion ETF is fine for nimble traders, but if that's not you, leave it alone.

Todd Shriber has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.