7

Due to the way gains compound on one another, and the daily resetting of leveraged ETFs, a 3x ETF will yield MORE than 3x of the underlying asset (in a bullish market), sometimes up to 10x gains in a yearly period.

This makes the long-term investment look very tempting, but any reward should come with risk, correct?

I've investigated the risks (risks associated with holding LETFs long-term), and have debunked a few of them myself:

  • In a stagnant market, a leveraged etf is subject to volatility drag and higher management fees, however the market has not been stagnant in the last 100 years. Any period of stagnation is short-lived, and similar to the principle of value investing, we would be looking to hold the asset for more than 5 years. Any sort of loss over some period (say 10% loss over 5 stagnant years) will be received again by only a 3.3% upswing in the underlying asset. I feel like this "risk" is sort of moot.
  • If the tracked asset falls 33% in a day, the fund will be wiped out (assuming 3x etf) If we invest in a broad-reach etf (SPXL, TQQQ) we would effectively eliminate this risk, because the underlying asset, being the market, will need to fall 33% but there are limits on the US market so that the market cannot fall more than 20% in a single trading day. (See trading curb ). Since LETFs re-balance each trading day, multiple -20% days will still never result in the LETF being "wiped out".
  • If the underlying asset falls, a significant portion of the investment will be lost Underlying assets tend to rebound. If there is a drop of 10%, the asset tends to recover by at least 11% in the future and considerably more. Assuming the underlying asset is the market (i.e. SPY, QQQ, NDAQ), it has always recovered and exceeded previous highs. Therefore this risk contributes more to timing than anything -- if I know I need to pull money out in exactly 5 months, the market could be down, but assuming I don't have a need to pull the money out at any specific point in time (withdraw either 5yr, 6yr, 10yr.. all are valid), I mitigate the risk of withdrawing during a low market, eliminating losses here.
  • Diversification is important so do not put all your money in one stock Something like the SPXL or TQQQ will track a diverse market, therefore diversification is built in.

With all of this, a 3x ETF tracking the market (SPXL, TQQQ) sounds like a clear winner. Historical records show a 15,000% gain over 11 years on TQQQ. If prior performance is any indicator of future performance then this would be an obvious choice.

Why is it that there is so much advice out there saying that I should not hold my money in a leveraged etf long term, what risks are they referring to that have not been covered, and is this a wise or foolish decision to put a significant portion of a portfolio into SPXL or TQQQ, compared to the underlying index (the market, which is generally considered a good investment)?

EDIT: the "market" referenced here is the US market

18
  • 1
    @user253751 ?? How about the leveraged ETFs that were actually suggested in the post? TQQQ recovered to previous highs last July, and SPXL this January. You are feeling awesome today even if you bought into either one last February. Commented Jul 14, 2021 at 13:11
  • 2
    @user253751 Well, one good reason is that no ETFs at a higher leverage exist, as far as I know. Commented Jul 14, 2021 at 16:12
  • 1
    @TylerM Ah, well apparently here in Europe there are 8x and 12x funds available. The trading platform I've used won't let you buy them without taking a test to show you are aware of the significant risk. Anyway, in March 2020, the 12x NASDAQ ETF dropped from about $200.00 per share, down to about $0.10. Not sure if this is a new incarnation now, because it should've been worth zero. Current share price around $15ish. That might be made up eventually, or it might not. If the NASDAQ crashes severely tomorrow, it may well go back down to $0.10. Commented Jul 14, 2021 at 16:57
  • 2
    @TylerM Surely if a 5x fund gets wiped out you may as well write it off and buy into the next 5x fund - what difference does it make whether you have $0 left over, or $0.0002? Commented Jul 15, 2021 at 8:46
  • 2
    Does this answer your question? Understanding downside of triple-leveraged ETF Commented Aug 9, 2022 at 13:45

2 Answers 2

3
+25

A leveraged ETF is not suitable for long-term use!

Moreso even than investing with your own source of leverage, a 'self-leveraged' ETF will dig itself into a hole with losses that it is difficult to climb out of.

Here is the fundamental error in the math underpinning your analysis:

"Any sort of loss over some period (say 10% loss over 5 stagnant years) will be received again by only a 3.3% upswing in the underlying asset. I feel like this "risk" is sort of moot."

The problem with this statement is that a leveraged ETF always maintains exactly 3x leverage, meaning following a loss, any subsequent gain is relatively minimized by the artificially reduced asset base, as the index sheds its own debt to avoid becoming '3.1x' leveraged.

Consider - if you have a margin account which you use to artificially create a '3x portfolio', and the underlying asset drops by 50%, unless you put further cash into your account, you will be left with 6x leverage, because your asset will have devalued but your original borrowed debt amount will not change. This now-increased relative leverage amount is what allows the net investment to 'catch up' to a non-leveraged alternative, when gains follow losses. VERSUS: For a 3x-leveraged ETF, after a 50% loss the leverage remains 3x, so the magnification of gains is relatively smaller than the initial magnification of losses.

Assume 3 scenarios where an index drops 3.3% and then climbs back up a 'neutralizing' 3.41% [note - 3.3% down then 3.3% up nets you back to only 99.81% of your original value] - in the first, we show no leverage, in the 2nd, we show a 3x margin account [or similar form of personal debt taken on for investment], and in the 3rd, we show a 3x leveraged ETF.

  • Scenario 1: $100 cash invested drops 3.3% to $96.7; $96.7 climbs up 3.41% to $100.
  • Scenario 2: $100 cash invested + $200 borrowed funds invested, drops 3.3% to $290.1 [$90.1 equity]. $290.1 climbs back up 3.3% to $300 [$100 equity, exactly returning to the same net equity value as in a case of no leverage].
  • Scenario 3: $100 cash invested in a 3x index drops 9.9% to $90.1. $90.1 climbs up 10.23% only $99.32! Long-term investment in a leveraged ETF account has failed us after a loss by returning poorer-than comparative results from either no leverage or a margin account, exactly as every financial guidance has warned it would.

Now let's prove out this theory with actual results comparing TQQQ vs QQQ https://portfolioslab.com/tools/stock-comparison/TQQQ/QQQ [amazing to me that you haven't even looked at the differential between the assets in your question - the historical track record is immediately self-evident - be INCREDIBLY careful at becoming overconfident. Do not assume that disagreeing with everyone around you is a sign that you know better!]

Merely using YTD values on TQQQ [down 56.11%] vs QQQ [down 17.82%], we can see that a 25% increase in the underlying would yield net gains gains for QQQ of 1.02725 [$1 * 0.8218 * 1.25]. Whereas TQQQ would still only be at 0.768% of original value, a remaining loss of 23.19% [$1 * 0.4399 * 1.75]!

In fact it's only coincidence that the YTD TQQQ loss of 56% is roughly 3x the 17.82% of the underlying. The comparative 12 month return for each as of today is -46% for TQQQ, vs -11% loss for QQQ - that's fully 4x the loss! Why? Because the underlying ETF effectively sheds debt after losses to maintain 3x leverage, which counterintuitively performs far worse than a self-leveraged margin account which would naturally increase its relative leverage after losses.

Final caveat on risk - that doesn't mean a margin account is low-risk! Risk in finance is variance in returns, and a margin account has a higher variance in returns compared with no leverage. Keep in mind that a margin account is not the only method to achieve personal leverage anyway - if you are a homeowner with a mortgage and also an investment account, you already implicitly are using overall financial leverage to invest, when you could instead have paid off your mortgage.

4
  • I appreciate the use of numbers and the effort you put into the explanation. Referencing a part in your explanation, I would like to make it clear that I'm not arguing for the sake of arguing -- in my mind, I just see a lot of these "risks" as being entirely mitigated by proper investing practices. ...With that being said, I did read over your explanation thoroughly three (3) times, to fully digest it. I still have issue with the "risks" presented, and I'll try to outline it as best as I can very soon.
    – Tyler M
    Commented Aug 11, 2022 at 19:28
  • @TylerM Forget the math that gets there - follow the link I offered to a data source showing the tracking of those two indices - they diverge over time, which is a natural, mathematic consequence of having a random walk of losses followed by gains. A leveraged ETF is simply not equivalent to personal leverage on the same asset. It simply will not recover from significant losses. It is not intended to - it is intended in theory for short term trades only. Commented Aug 11, 2022 at 20:30
  • ITYM "your original borrowed debt amount will >>not<< change" Commented Aug 12, 2022 at 14:06
  • @dave_thompson_085 Thanks, fixed!\ Commented Aug 12, 2022 at 15:47
0

Financial products should be "used as directed," unless you are an experienced finance pro. It's best to take the warning on the TQQQ webpage seriously, and avoid the product for long-term investment:

ProShares' returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period

Long-term leverage for ordinary investors is still a dream, if not a pipe-dream, despite the obvious benefits. The authors of Lifecycle Investing advocate that young people lever up 50% by using the full margin privileges in a taxable brokerage account. But this means forgoing the tax benefits of an IRA. Leverage is not allowed in IRAs.

4
  • Can you provide a source stating that the leveraged ETFs are not allowed in an IRA? I currently have a portion of my Roth IRA invested into TQQQ.
    – Tyler M
    Commented Jul 14, 2021 at 16:38
  • As you pointed out, ProShares protects its self from liability by stating that the returns on any given period will almost certainly not be the same leverage as what it tracks daily. This is fine though, as it is what causes the highs to be so high due to the compounding. I don't see it as a risk, rather it describes the nature of how the fund behaves.
    – Tyler M
    Commented Jul 14, 2021 at 16:40
  • Sorry i think i misunderstood -- you are saying the authors recommend buying on margin, which is not allowed in IRA - correct?
    – Tyler M
    Commented Jul 14, 2021 at 18:00
  • @TylerM That's right. You can't use direct margin in IRAs, but you absolutely can access leverage via these ETFs. Commented Jul 14, 2021 at 22:04

You must log in to answer this question.

Not the answer you're looking for? Browse other questions tagged .