What Netflix’s Deal With Warner Bros. Highlights About Leveraged ETFs

Anyone who happened to be holding a leveraged Netflix ETF leading up to last week’s news likely got stung … stranger things have happened.

The company’s blockbuster deal with Warner Bros. Discover sent Netflix’s stock lower, and the target’s stock upward, amid news of a hostile takeover bid by Paramount Skydance and indications by President Trump that he’s not in favor of the acquisition. With Netflix stock down 9.4% over the past five days, 2X leveraged ETFs are unsurprisingly down by about twice that amount. But the stock and corresponding leveraged ETFs are a case study in “decay,” or the tendencies of such products to considerably lag the securities they’re designed to track, particularly when stock prices are volatile. For example, while Netflix stock is up by 9% year to date, the Direxion Daily NFLX Bull 2X Shares (NFXL) is down by 5.5%. If clients are trading leveraged ETFs on the side, advisors might want to help them understand this.

“These are path-dependent,” said Ed Egilinsky, head of global sales and alternatives at Direxion. “After one day, there is going to be compounding. And that leverage can work for or against you … If something is volatile, with not a lot of directional movement, you can lose a lot of money.”

Don’t Look Up (or Down)

That largely explains not only why NFXL is down while the stock is up, but also why Direxion’s Daily NFLX Bear 1X Shares ETF (NFXS) is also down, in that case by over 14% year to date. The divergences in returns support something that the company makes clear about leveraged ETFs: They are intended for experienced traders and not meant to be held for very long. 

There are two reasons why leveraged ETFs almost always lag their target stocks over time:

• Volatility decay: “When a stock or an investment loses a certain amount of money, it needs to go up by a higher percentage to get back to even,” Morningstar manager research analyst Zachary Evens said. “Leveraged ETFs multiply that effect.”
• Roll cost: The cost of options used by funds is an incremental charge that isn’t very noticeable on an intraday basis. “This is a built-in mechanism that will lose the fund money over longer periods of time,” Evens said.

Patterns Emerge: As shown by Netflix’s top movie of all time, KPop Demon Hunters, what’s apparent on the surface can be different from what’s below. For leveraged ETFs, that comes down to swaps. “It’s hard for investors to see what’s actually inside them,” said Michael Martin, vice president of market strategy at TradingBlock, pointing to NFLX’s 14.5% allocation to stock with the remainder going to swap agreements. “The leverage does not come from the swap contract. It comes from the ETF choosing to size those swaps at two times the fund’s assets.”

Leveraged ETFs are like matches: Useful, but hold them for too long and you risk getting burned. As Direxion’s Egilinsky noted, every day is a new day. “Your timing matters here,” he said. “These are basically high risk, high reward vehicles.”