MSTX: The Case Study For Bad Leveraged ETFs

Summary I have mixed feelings about non-productive, speculative assets like Bitcoin and have never given BTC itself a buy rating. These feelings also extend to MicroStrategy (now “Strategy”), which leverages debt to buy Bitcoin, emerging as a bullish, “leveraged” bet on BTC. The Defiance Daily Target 2x Long MSTR ETF offers even further leverage on MSTR, and therefore BTC. However, it is a very poor investment. I am issuing a strong sell on MSTX for several reasons, which I discuss in this article. Leveraged ETFs are very dangerous to investors and traders alike, especially those on single stocks. Introduction Regular readers of mine will know that I have mixed feelings about non-productive, speculative assets like Bitcoin ( BTC-USD ). I’ve never given BTC itself a buy rating , and I recently discussed how I’ve completely liquidated all of my cryptocurrency holdings. Before it ran up 93% from the date of my coverage, I gave “Bitcoin Development Company” MicroStrategy ( MSTR ) a hold rating as well. Seeking Alpha Sometimes, it pays not to listen to me, turns out. Had folks disregarded my advice to avoid MicroStrategy stock — which I believe is just “Strategy” now, based on the Seeking Alpha articles released about it recently — they would’ve made bank. There may be some point to being my contrarian at times; I’m not always right. However, some investors who were correct about MSTR may have lost out immensely by choosing to juice up their exposure with the Defiance Daily Target 2x Long MSTR ETF (NASDAQ: MSTX ). Since that article was published, here’s how they both have performed: Data by YCharts I could say that this fund “does what it says on the tin,” which is my new favorite saying regarding leveraged ETFs since reading this report from my colleague Seeking Vol. The fund “seeks daily leveraged investment results of two times the daily percentage change in the share price of MicroStrategy Incorporated ((MSTR))…” according to its provider, Defiance ETFs . This daily effect means that over long periods of time, we can see exactly what we see that in the chart above, with long-term underperformance despite overwhelmingly positive returns in the underlying. While MSTR itself is up over 100%, the volatility of the stock eroded MSTX’s return down to 52%. Truth be told, the fund can, in very short spurts, duplicate the exposure across multiple days. It makes no promises, however, and this may be a coincidence over the last five days. Data by YCharts Otherwise, it is really only daily leverage. That means that this instrument is only suitable for day trading, as it cannot be routinely trusted to create leverage in the right direction over time. This shouldn’t be news to the leveraged ETF community, who may often choose to disregard warnings from the SEC , such as: Leveraged and inverse ETFs typically are designed to achieve their stated performance objectives on a daily basis. Some investors might invest in these ETFs with the expectation that the ETFs may meet their stated daily performance objectives over the long term as well. Investors should be aware that the performance of these ETFs over a period longer than one day can differ significantly from their stated daily performance objectives and may potentially expose investors to significant and sudden losses. Additionally, there are also prospectus-level warnings: The Fund is not suitable for all investors. The Fund is designed to be utilized only by knowledgeable investors who understand the potential consequences of seeking daily leveraged (2X) investment results, understand the risks associated with the use of leverage, and are willing to monitor their portfolios frequently. The Fund is not intended to be used by and is not appropriate for, investors who do not intend to actively monitor and manage their portfolios. Volatility Drag in Leveraged ETFs One of the reasons that MSTX has failed to outperform MSTR over its lifespan despite MSTR itself doubling during that time is that the performance of leveraged funds cause volatility drag (or “volatility inflation” depending on your take). Smarter men than I have already covered this, so I first want to thank Aptus Capital Advisors for publishing a case study on MSTX. In that study, Aptus first explained volatility drag itself: The difference between arithmetic and geometric returns helps explain why leveraged ETFs often underperform expectations. Here are some examples of how each is calculated: Arithmetic Return: A simple average of returns, which does not account for compounding. Example: The arithmetic return of -10% and +10% is: (−10%+10%) / 2 = 0% Geometric Return ((CAGR)): Incorporates compounding and represents the true growth rate of an investment. Example: The geometric return of -10% followed by +10% is: (1−10%)×(1+10%)=0.99−1=−1% Since geometric returns account for the compounding effect, volatility negatively impacts long-term performance—this phenomenon is known as volatility drag and is especially relevant for leveraged ETFs. A simplified formula for the geometric mean return is: Geometric mean = Arithmetic mean – (StdDev² / 2) Volatility creates a “drag” on returns, which worsens with higher leverage. An example for an asset with 50% volatility: Unlevered: 50%² / 2 = 12.5% drag Daily leverage: (50% x 2) = 100%² / 2 = 50% drag In this example, with 2x leverage the drag quadruples, require exceptionally high arithmetic returns to offset it. Aptus Capital Advisors So if volatility drag is a natural part of leverage, why does it matter beyond us understanding that it means returns won’t be perfect? Well, it helps us see just how dangerous this factor can be when applied to instruments that are too volatile (e.g., MicroStrategy). Because MSTR is so volatile, the drag that MSTX generates is so much greater than that of many other leveraged funds, where this drag has a far lower effect on the fund. MSTR’s volatility exaggerates this effect dramatically, and it results in terrible performance compared to the long-term returns of MSTR itself. Aptus did a 5yr backtest where they simulated MSTX’s strategy to demonstrate how this would have affected MSTX terribly even before its launch in 2024. They were even kind to MSTX by assuming that there was no cost or friction associated with the leverage (which is not true in the real world). Aptus Capital Advisors If you want more info about this phenomenon and why it makes these kinds of leveraged instruments undesirable, but doesn’t make all leverage unattractive, I recommend this article from Corey Hoffstein , founder of Return Stacked Portfolio Solutions, the folks behind now-famous leveraged ETFs RSBT , RSSB , and others. MSTX Holdings The strange behavior of the fund is partially a mathematical issue with volatility drag, but also because of the variety of tools necessary to create the proper leverage. The fund has to employ several swaps, call options, and a long stock position to achieve its target leverage, which all incur their own costs and drag. Defiance ETFs This is not unusual behavior for a leveraged ETF, but most successful leveraged ETFs were built atop indexes that are far less volatile than MSTR is. They suffer less from volatility drag, and the other costs of leverage employed on more-thinly traded securities like MSTR compared to an index like the Nasdaq 100 with TQQQ . MSTR Is Already Leveraged One of the core issues I want to raise here for investors considering MSTR as an alternative to the leveraged version (given that you agree with my sell thesis on MSTX and would avoid it even if you are bullish on MSTR) is that the company itself operates as a leveraged bet on Bitcoin. As I covered in my past article on MSTR, the company issues convertible debt to buy Bitcoin as its central strategy. This means that the company dilutes its own shareholders in order to buy Bitcoin, with shareholders hoping that Bitcoin appreciates more than they are diluted, resulting in outsized gains compared to buying Bitcoin on your own. MSTR, as large as it is, has access to more favorable debt rates than consumers, and so acts as cheaper Bitcoin leverage than margin for most investors. I don’t believe that this is a prudent strategy, leading to my hold rating on MSTR that I am still maintaining regardless of its performance. Suitability To that end, I am giving a strong sell rating to MSTX on its inability to capture the long-term trends of MSTR. While it does provide for daily and even multi-day accurately leveraged exposure (up to several days in a row, but no promises), it is just a trading tool. Leveraging an already leveraged asset in MSTR is not a winning proposition due to the volatility drag/inflation that occurs in trading, leading to worse outcomes than a simple long stock position in MSTR. I cannot recommend any investor hold MSTX, and believe that investors are far better served by investing in MSTR outright. Even to that end, I do not recommend buying MSTR, and instead recommend holding Bitcoin inside a productive, no-upside-cap wrapper like the MAXI ETF . However, currently, I have eliminated all of my speculative and risky asset exposure, and so I am no longer holding MAXI either in our current market environment. Conclusion Ultimately, the Defiance Daily Target 2x Long MSTR ETF is not a suitable vehicle for any investor and has earned a strong sell from me, due to its increased exposure to volatility drag that has resulted in performance longer than a day or several days at most being heavily distorted from its underlying asset such that it can dramatically underperform even during positive periods for MicroStrategy. I am not bullish on MSTR itself, which furthers my counter-recommendation for MSTX. MSTR employs leverage on its own, which I believe is irresponsible and unlikely to play out well given my long-term bearish view of Bitcoin. In the short term, I am also bearish on MSTR and Bitcoin as I see further pain and volatility to come to markets due to our current geopolitical trade tensions . Thanks for reading.

Source: Seeking Alpha