By: Dividend Sensei
Leveraged ETFs seemingly offer the average hands off investor instant diversification while enjoying the profit boosting power of 2X or even 3X leverage. You can even choose the direction you thing the price will go, with bear and bull themed ETFs. So theoretically someone who can time the market well could benefit from both a rising and falling market.
One of the most popular leveraged ETFS is the ProShares UltraPro QQQ (TQQQ) which is a 3X leveraged Nasdaq ETF. Since debuting in 2010 TQQQ has smashed the Nasdaq by 10 fold, rising a sensational 35.3 times compare to a “mere” 4.4 fold increase in the tech heavy Nasdaq. How is that possible? Shouldn’t TQQQ have only gone up 13.2 fold since its a 3X leveraged ETF? The reason TQQQ ended up having effective leverage of 8X over the past eight years is because the leverage it uses comes from daily options that means the ETF attempts to achieve 3X the daily swings in the Nasdaq. This creates two problems. First is beta slippage. This is caused by the daily resets and means that if the Nasdaq is highly volatile to both the upside and downside then the ETF will loss value over time even if the Nasdaq ends up trading in place for several months or quarters.
But to achieve the stunning returns it did? Well that’s due to a historical fluke. Specifically the fact that, despite a few modest corrections this bull market, the entire market has for the most part seen very low volatility. The Nasdaq in particular has generally trended up if only slowly, followed by low volatility periods of shooting upwards with almost no retreats. Combined with the daily reset nature of its option based leverage strategy that’s how TQQQ managed to achieve far greater returns than one would expect. However leverage is always a double edged sword and guess what? In a bear market where richly valued tech heavy Nasdaq is likely to fall fast, hard, and with minimal volatility, the same mega leverage effect is going to work against anyone holding this leveraged ETF.
This means that any 30+% decline in the Nasdaq is going to effectively wipe out anyone long TQQQ. The Nasdaq almost always falls at least this much during bear markets which means that no matter how much money you make in this ETF (including a 35 fold multiplying of your investment) at some point you are almost 100% guaranteed to lose it all. That means that you need to make sure to sell near the top of the current bull market which is something that every hedge fund, private equity firm, and major Wall Street bank is trying to guess at (and with hilariously terrible success historically). Leveraged ETFs are like playing blackjack (where you double your money if you win) and then letting your money ride every time. A few lucky hands and you’ll end up with a vast fortune. But the moment luck turns against you (as statistics says is inevitable) you lose it all.
Behavioral finance studies show that it hurts twice as much to lose money as to make money. So imagine how devastating it would feel to watch your nest egg soar to the heavens and fill your head with champagne wishes and caviar dreams. Only to have it all vanish in the blink of an eye (stocks take escalator up but elevator down). At the end of the day making a fortune doesn’t mean diddly, it’s what you keep over the long-term that counts. So take it from someone whose made and lost three fortunes in my 22 year investing career. Avoid get rich quick schemes like the plague and stick to solid time tested strategies that are as close to a sure thing (over the long-term) as you can get in life.