Investment — Part 3— Leveraged ETFs
By: Jeff Axup
Tags: Stocks, Investment, Investing, Etf, Stock Market

THE ARGUMENT AGAINST LONG-TERM USE

Leveraged ETFs are commonly described as vehicles for short-term or sub-1-day investments. There have been a number of strongly-worded business articles admonishing the people who are dumb enough to buy and hold leveraged ETFs for longer than a day. This viewpoint starts from the description of the ETFs by the fund providers, and proceeds on to so-called experts in business journalism and academia.

“This ETF offers 3x daily long leverage to the NASDAQ-100 Index, making it a powerful tool for investors with a bullish short-term outlook for non-financial equities. Investors should note that TQQQ’s leverage resets on a daily basis, which results in compounding of returns when held for multiple periods. TQQQ can be a powerful tool for sophisticated investors, but should be avoided by those with a low risk tolerance or a buy-and-hold strategy.” — ETFdb

The WSJ has an article titled “This Fund Is Up 7,298% in 10 Years. You Don’t Want It.”. Their argument seems to be that you can lose money if you pull your money out when the market is down — which is true of nearly any stock investment. They warn:

Yet fewer [stocks] can rival its risk, and you can lose money on it even in a flat or rising market. — WSJ

This is exactly the nature of borrowing money to invest. If you place the borrowed money in an investment that doesn’t appreciate, then you lose money, because you are also paying interest for the loan. If you don’t expect a house to appreciate in value, then don’t buy the house. They also state something else, which is far more important.

The fund returned an average of 51.5% annually over the 10 years ended July 31, making it the single best-performing mutual fund or ETF of the past decade. … As I’ve warned over the years, almost anything can happen when you own such a fund for longer than one day. — WSJ

Everyone seems to be focused on the fact that long-term investments may go up or down, and then conclude that you should only do short-term investments. Would you avoid buying a house because there might be a temporary dip in the market? Just because a housing market slumps for a month doesn’t mean you can’t hold the house for years, and then refinance when the market is high again. The articles goes on to say:

If you’d bought TQQQ three years ago, you would have more than tripled your money by this week — but only if you somehow managed to hang on the whole time. — WSJ

This hits the nail on the head. If only the investor had patience, for a mere three years, they would be much richer. It’s not “hanging on”, it is investing and waiting for the right time to exit — in short it is following a sound investment strategy, not investing based on emotions. I have personally held TQQQ for periods of 8 months and 4 months, and have seen both the dramatic drops in value and corresponding dramatic increases in value. Buying in at a high-point is not a wise idea.

The article goes on to explain the impact of the cost of borrowing/leveraging in the fund over the course of a year.

In short, if you hold this fund over the course of a year when the Nasdaq 100 is flat, you are highly likely to lose money — potentially nearly all your money. Even at a moderate, and historically normal, 20% volatility, the fund would lose 11% in a flat market over the course of a year, estimates ProShares. — WSJ

First of all, when is the Nasdaq 100 flat? As discussed in previous articles, the stock market always goes up, given sufficient time. So it isn’t flat — particularly if you bought during a large downturn. Second, it is leveraged, so it overreacts to the market, and small upswings are eventually amplified. Also, paying 11% to borrow a significant amount of money, with the strong likelihood of returning a 100–200% return, is an excellent deal.

The second problem with this logic is the definition of “losing money”.

You only “make money” or “lose money” when you sell your shares. So quite simply, wait until the investment is up, and then you will make money when you sell. Never sell when the market is overreacting to temporary downturn. Your money is not “lost” during a temporary downturn — it is in cold storage.

The article seems to equate “your investment value is currently down” with “you have lost money” — nothing could be further from the truth. My stock investments are regularly “temporarily down” in value, but I very rarely “lose money”.

Another aspect of the idea of “losing money” is the notion that somehow your “investment disappears”. Let’s be clear, if you own 100 shares of TQQQ, those shares aren’t going to disappear, unless the unlikely event that the fund closes. (Even then they don’t disappear, they just get sold at the current lower value.)

It’s not like your shares get reduced over time, or you end up with 10 shares instead of 100 after a year. Your shares don’t inherently devalue over time (like an option). You still own the 100 shares at the end of a year, or 5 years (unless the stock splits). It doesn’t cost you anything to hold those shares.

You’re not paying a monthly fee or interest separately — any operating costs for the fund are built into the share price. Once this understood, it becomes a simple act of buying the shares low, tracking the cost-basis of the investment, and then waiting until the share price returns to the all-time high, or above, as it always does. I have done this several times already and plan to continue doing so. I have friends who have received similar results.

“We don’t promote long-term use of these products,” he says, “and the vast majority of investors don’t use them in that fashion.” — Michael Sapir, ProShares Chief Executive

They certainly don’t, and neither do most trading houses that make more money off of frequent trading. There is a conflict of interest in the CEO telling you how to use their product in a way that earns them the most money. It’s like a company advising you to use the monthly subscription rate instead of the yearly rate, when the latter is cheaper. Also, hidden in this quote is the voice of the legal team trying to stave off potential lawsuits. Just because one method is advised, doesn’t mean that an intelligent investor can’t use a different strategy with the fund. The ProShares website goes on to say:

Due to the compounding of daily returns, holding periods of greater than one day can result in returns that are significantly different than the target return and ProShares’ returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. — ProShares Web Site

This reads like a statement of “how stocks work”. Holding a stock for a day or two, may have a different result than your target return for the investment after several years. The effects will be bigger when using leverage. Unlike some websites that say that TQQQ “is not intended for investments of more than one day”, the description above actually seems to leave a door open for the idea of longer investments.

The WSJ article goes on to talk about “inexperienced traders”.

The brokerage app Robinhood caters to inexperienced individual traders. The number of its users owning TQQQ rose from about 10,000 in January to nearly 26,000 by late July, according to Robintrack, an independent website that has been monitoring how many Robinhood accounts hold particular stocks. Should Nasdaq stop rising, some of these TQQQ buyers could be in for a hard landing. — WSJ

Business and stocks news are big on statistics and have almost zero testing or science behind them. We won’t know how those 16,000 new investors did with their TQQQ investment until it is tested. The presumption seems to be that they lost money, but perhaps they doubled or tripled their money? Also, there is again the presumption that the “NASDAQ” will stop rising. Temporarily, yes, there will be downturns, but in the long-term the NASDAQ (the tech sector of the entire stock market) is going to keep growing.

One of the respondents to the WSJ article understands the range of how leveraged ETFs can be used better than the author.

I have been thankful for TQQQ in my portfolio. It’s nice that there is a way for investors who understand the risks to buy leveraged securities without having to belong to a hedge fund. I’ve had TQQQ in my portfolio at the beginning of 2017 and it’s been a massive winner. I’m neither a day-trader nor a buy-and-hold investor. For those who understand the risk, have the means to live with the volatility, and strategies to avoid emotional decision-making — this fund is a wonderful complement to the portfolio. — Logan K

Another respondent said something similar:

It’s odd that the ProShares CEO says that they don’t recommend investing in this product for the long run. I view it exactly the opposite. Using this product for the short-run is extremely dangerous because it requires that you time the market correctly, which is nearly impossible. However, if you are truly investing for the long run, it could be a good product. Since the late 1800s, there has never been a single 20-year period when the U.S. stock market has had a negative return.

Another anti-long-term article in the journal AAII mentions the potential problems of choppy markets, volatility drag, and tail risk.

Not only do leveraged investments tend to underperform in choppy markets, but they leave the investor with the possibility of a catastrophic loss. — AAII

Choppy markets inevitably become stable markets part of the time, and “catastrophic loss” is not catastrophic — it is limited to 100% of your original investment. If you invest $1000, the maximum you can lose is $1000. This is very similar to options, where the maximum you can lose is the amount you put in — in other words, you downside is finite, and your upside “infinite”. This is a rare situation that can be used to your advantage.

If you want to look at something that really has a high risk level, examine short sales where you can lose more than you put in. You can also look at entrepreneurs doing startups, which have about a 90% failure rate. (I personally tried to start three of them and lost money on all of them.) Much of society seems to have gotten so used to modern living environments with near-zero-risk, that they don’t understand that taking insufficient risk leads to stagnation and lack of innovation. What I look for is calculated, balanced, managed risk, not zero-risk.

Volatility drag is another argument for not using leveraged ETFs long-term. The author actually explains why this isn’t insurmountable in the article:

If there is volatility drag, why have LIPs like ProShares UltraPro QQQ had such excellent long-term performance? The key is having a high compound return for the index. If the compound return for an index is high enough, the multiplication of that return can more than offset the negative effect of volatility drag. — AAII

So choosing a market sector with high growth potential (e.g. tech, not REITs) is all that is necessary, because the high return will offset the drag from the ongoing leverage costs. Additionally, since your initial shares are never lost, you can simply wait until the return is high again, and then exit at that time.

The author views volatility as negative, because of the drag effect, but there is perhaps a more important positive aspect to volatility.

If your goal is to buy low and sell high (or short) then you are specifically looking for an investment with high volatility — the perfect candidate investment would be one that wildly and swings between very high worth and very low worth as rapidly as possible.

Leveraged ETFs such as TQQQ and SOXL have increased operating costs due to the volatility, but they also offer an optimal trading opportunity because of the same trait.

Although volatility had been low since January 2010, it has spiked with the onset of coronavirus pandemic uncertainty. Should volatility remain at elevated levels, I would expect ProShares UltraPro QQQ to underperform. — AAII

COVID-19 has indeed caused huge uncertainty and volatility, but contrary to this, it has created an unprecedented opportunity to rapidly buy low and sell high (BLSH) for an over-performing investment.

The author also points out that tail risk (extreme risk and negative returns) can result in fund closures. In this case the value of shares may be near zero and lead to a loss of most of the original value of the investment. This is definitely a potential risk, if the original fund is in an unstable area that doesn’t offer long-term value, or is unlucky enough to get hit by a black-swan event. However, holding a leveraged-REIT during a mortgage meltdown, or a theatre ETF during COVID isn’t a great idea regardless of whether it is leveraged or not — either way you can lose 100% of your investment. (For example, as of this writing I am down 88% on ACB, a single Canadian marijuana stock.)

The AAII author is very risk-averse:

In my view, the threat of tail risk makes buy-and-hold investing in risky sector LIPs too perilous. — AAII

There is almost always the risk of losing nearly 100% of your investment, regardless of whether it is leveraged (just look at ACB). A good leveraged investment returns 100+% each year. That means that after a year, you could lose 100% of your new investment the following year, and still be just fine. Taking 5% of your net worth and putting it towards an investment with likely 100% repeating annual returns, and a small risk of a one-time 100% loss of the original investment amount, seems like an excellent bet with small downsides. After one year it pays for itself. It is also worth noting that we’re not discussing individual stocks — an ETF is already diversified and consequently lower risk — we’re just adding a layer of risk to something more stable.

Additional advice from the AIII author concludes:

As an alternative to buy-and-hold investing in leveraged investment products, consider the strategy of swapping a leveraged investment for an unleveraged investment during periods of high volatility and economic uncertainty. — AAII

Exiting during times of widespread fear and uncertainty is the opposite of what a seasoned investor would do. High volatility and economic uncertainty is the perfect time to buy, when the market is scared and investments offering solid long-term value are artificially low.

There are numerous other articles citing the dangers of leveraged ETFs, including one in ETF.com, and another in the “Evidence-Based” Investor. In the first article, the author warns:

Stop buying triple-leveraged ETFs like UWT and holding on to them in the hope that when the underlying securities do pop, you’ll reap triple the benefits. That’s not how these products work. You will be burned, and it will happen sooner rather than later. — ETF.com

Unfortunately, this literally is how they work (minus fees and ongoing operating costs). The underlying securities won’t “pop” — but they will return to normal market levels. It might not be exactly 3x the normal stock value, but it should be close to it, and sometimes it’s more than that. The example the author gave was UWT (crude oil), which is literally the worst possible sector one could find to invest in. Oil is likely to go down regardless of whether it is leveraged or not, and thus it is not a good representative test case.

In-line with actual scientific analysis, instead of supposition and untested hypotheses, let’s see how the author’s prediction worked based on historical stock market data. Let’s use a more stable sector, with a strong future ahead of it (SOXL, 3x-leveraged, semiconductors), instead of oil. Starting from the time of the article (March, 2020) — after 5 months, the market returned to the previous ATH (all time high), and then greatly surpassed it in around 9 months. Anyone who purchased when the author advised against it would have “reaped” quadruple benefits. I was one of those people (although I sold a little early). The problem with business reporting is that there’s little verification of the accuracy of predictions after the fact. You might say this rapid (9 months) uptick was due to chance, but if you look at all of the other historical drops in SOXL (see chart at top of article), the same thing happened shortly after — so this is very likely to be a consistent pattern.

The author discusses the same “daily erosion” problem where your stocks lose value after each daily reset of the leverage factor. This would be a problem if you were using these short-term, but eventually when the market recovers, you will still own the same number of shares, and the fund will still be borrowing money to extend your investment, and you will still get some kind of multiplier (perhaps less than 3x) when the market is high again. The chart above shows the inconsequential “drag” on the value of the shares from the time of writing the article, until the new ATH in Oct-Nov timeframe. The leverage and inevitable rise in stock value more than makes up for any drag here. If you just glanced at this chart, you could be forgiven for thinking there is no drag at all.

The author concludes:

There’s nothing wrong with leveraged and inverse ETPs held by the right hands. They’re great instruments for institutions and traders who need ultra-short-term hedging instruments and risk management tools.However, these products were really designed only for this audience, not for retail investors like you and me. — ETF.com

Just because a product was designed for one purpose doesn’t mean it can’t be used in other ways that work. A screwdriver can be used in many ways, and it can be effectively used by novices. Saying only licensed contractors are allowed to use screwdrivers just unnecessarily drives a lot of business to the contractors.

There seems to be this dogma that leveraged ETFs only work for short-term investments, but actual testing shows otherwise. Who should you believe, the person who says it doesn’t work based on theory, or the person who has empirically tested it and has a working demonstration?

Something is wrong with the theory that leveraged ETFS are only short-term vehicles — and it is time that the theoreticians caught up with those empirically validating (or invalidating) those theories. My suspicion is that these authors are stuck in short-term mindsets, and are not including the scenario of “buy when the market is down” (BLSH) in their projection scenarios. They are also looking at leveraged-ETFs across all market sectors, instead of looking at how they perform in specific high-performing sectors. A 3x-Oil-ETF is not the same thing as a 3x-Tech-ETF. If you look at a poorly-performing sector you will get poor results, regardless of the fund structure.

All of these authors range from “be skeptical and knowledgable,” to “don’t do it at all.” Being skeptical is great, but invest a small amount of real money, do real experiments, and then report on the results.

The only thing that matters is the amount of actual cash you exited with, minus the amount you put in, corrected for annualization.

More recently there have been a few voices questioning the “short-term-leveraged-ETF” dogma, and using quantitative back-testing to historically validate the trading strategies they are proposing. One of them titled: TQQQ: Hold Long But Not Too Long, A Data-Driven Analysis concluded that TQQQ was best held 1–5 years. Another article by Double Digit Numerics has a detailed mathematical analysis disproving the “myth about long-term use of leveraged ETFs.” Other traders not exhibiting a herd mentality are trying experiments for themselves, such as the respondents to some of the above articles. I expect there will be more articles forthcoming that find data to support the long-term usage hypothesis, probably coming from independent blogs and contributors who dive deep and test.

HOW I INVEST IN LEVERAGED ETFS FOR LONGER TIME PERIODS

Investing longer-term in a leveraged ETF isn’t rocket science. Here is the basic algorithm I use. Spoiler: it boils down to BLSH using a leveraged ETF.

Progressively buy-in as the market drops, continually lowering your cost basis. You can sell when the stock value returns to all time high (ATH), or when it reaches X% above ATH, or when your investment gives the desired return (e.g. 200%). Pay your taxes and calculate your net return. Re-invest most of your earnings.

It is worth mentioning that not all ETFs are the same. An ETF that targets oil, or travel, or real-estate, is not the same as ETFs that target big tech, or bio-tech, or electric transportation. I personally like TQQQ and SOXL because they are hard-core tech that the future will be built on top of. Investing in oil or gold is probably always a bad idea — regardless of whether it is an individual stock, ETF, or leveraged ETF.

TESTING

The cycles for this type of investing are longer (3–12 months typically), so it takes years to run a series of real-world tests with real money. So far I have conducted two cycles of testing with TQQQ and one with SOXL. I purchased a house with the proceeds. A friend shadowed these investments with their own money and roughly the same time-frame, and got similar results.

I have algorithmically back-tested quite a few (maybe 1000) variations on the above strategy, and there are certain percentages that work better than others for particular funds, but the general principle is always the same.Using back-testing I have watched how these funds behaved in various scenarios (up-market, down-market, different durations, different buy-in percentages, different exit strategies, etc), going back up to 6 years. Needless to say, if I had figured out this strategy earlier, I would be richer now. During previous drops in the market I didn’t know what to invest in, didn’t have sufficient liquidity, and didn’t understand that the market would eventually recover.

The strategy I am describing works consistently because the overall market goes up over time, but downturns also regularly occur (although they happen at an unknown time.) More detail on the resulting returns from these experiments is listed in the TESTING section of Part 1 of this series.

NEXT STEPS

I am continuing to run tests of this investing method, and also expanding into new methods. Just to up the ante on the topic of leveraged-ETFS, I am currently running a long-term investing experiment using an inverse-leveraged ETF to take advantage of market downturns. I may report more detail on the structure of the tests and results in the future, and I may expand to other investment topics as I evaluate them. Follow me on Medium to get updates as they come out.