Why isn't my fund tracking the underlying index?

This is a common question: Why isn't my fund tracking its underlying index?

Lets use FAS for this example.

First of all, make sure you are on the correct index. While it may be very close, it does not track the DJUSFN.

Direxion aims to grow its Net Asset Value by approximately positive three times of the momentum of its underlying index, the Russell 1000 Financial Services Index (RIFIN.X).

The second idea you must understand is that Direxion does not set the price of this ETF.

You do.

Supply and demand controls the price of the ETF, and traders and investors use the information they have to be able to value it properly.

Direxion is responsible for making sure the Net Asset Value (current value of everything the fund owns - liabilities) tracks the underlying index the best that they can, not the price you pay for the ETF.

You can find out the daily Net Asset Value by either visiting Direxion.com and finding the nifty CSV sheet that they provide, or by visiting FAS.IV on google finance to see its movement throughout the day.

Today, the RIFIN.X closed -6.14%, so you would expect around -18.42% if Direxion could be perfect, which by the way, it does not guarantee.

In reality, FAS closed -13.36%. But, FAS.IV was -18.69%. That is a much closer number to the target. So, what happened here?

With the creation unit available, and hedge funds and day traders participating in this ETF's trading you would expect see the ETF trade at its NAV, for otherwise, there would be arbitrage.

But at the end of the day today, you could scoop up FAS for $6.12 when it was only worth at NAV $5.96. This premium (+2.68%) leads us to believe that the people that are long on this stock are sentimental over it--that is, they either don't want to give it up, or feel that it will rebound again quickly. It also hints that maybe hedge fund and swing traders are not participating in the sell off of this stock today.

A simple example of this arbitrage opportunity:

Hedge fund sells short 100,000 FAS 6.12

Goes to Direxion and buys creation unit of 100,000 FAS @ NAV 5.96

Returns short shares for a profit of 2.68%, or $16,000 with exceptionally low risk.

These sorts of transactions keep the market in check.

So, why again didn't FAS track today?

• Supply/demand imbalance
• Participation from funds may have been minimal
• Emotions from individual investors
• Trader sentiment may be that the FAS will go back up tomorrow, and do not want to incur execution fees to sell/rebuy
• There is also the possibility that the street thinks something will happen overnight (Obama speech possibly) that will boost the RIFIN up pre-market, and therefore not able to buy it on the news until it was too late.

You should note that, while these ETF's might not track perfectly, they are probably tracking well enough for the retail investor/trader's purposes. I don't worry about it myself.