Leveraged ETFs
To lever or not to lever?
Here’s an interesting question:
Imagine you invested $10,000 into Nasdaq-100 (QQQ) and triple-leveraged Nasdaq-100 (TQQQ) at the end of 2010. Your $10K investment in QQQ would have grown to $122K — a cool 12x return.
Hold on to your answer — we’ll revisit this in just a moment.
In 2008, Ian Ayres and Barry Nalebuff (both professors at Yale) argued1 that it was responsible for young investors to use leverage while investing. Their logic was that when you are young, your earning power is at its lowest, and you don’t have a lot of money to invest. But, given your long time horizon, it’s precisely when you should be taking the maximum risk.
Let’s take a hypothetical investor, Alan, who starts investing at 25. Alan’s starting salary is $50K, and he puts 10% into stocks.
So, at 25 (with 35 years to retirement), he is investing $5K into stocks.
Fast-forward 20 years, and Alan is now earning $250K and continuing to invest the same 10% in stocks.
So, at 45 (with only 15 years to retirement), he is investing $25K into stocks.
The problem highlighted in the paper is that Alan is investing too much too late in his life. He is leaving his earlier years underutilized in terms of equity exposure and time for compounding.
According to the researchers, the optimal strategy would be2:
Alan borrows an additional $5K (2:1 leverage) when he is 25 and makes his total investment $10K.
Reduces the leverage to 1.5x when he is 35
Finally, stops using leverage closer to retirement
By doing this, Alan can increase his exposure to stocks and grow his portfolio exponentially. This strategy helps you diversify over time and overcome the problem of having too much invested in equities too late in your life.
The insight behind our prescription comes from the central lesson in finance: the value of diversification. Investors use mutual funds to diversify over stocks and over geographies.
What is missing is diversification over time.
The problem for most investors is that they have too much invested late in their life and not enough early on. — Life-Cycle Investing and Leverage
Power of Leverage
Coming back to our question, here is how our investment in QQQ & TQQQ would have performed:
At first glance, TQQQ (Triple leveraged Nasdaq-100) performed as expected — providing ~3x the return of the Nasdaq-100 (QQQ) index.
That’s until you look again and realize that the chart is in log scale.
$10,000 invested in QQQ in 2010 would have grown to $120K (12x return)
$10,000 invested in TQQQ in 2010 would now be worth $2.1 Million (210x return)
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To understand what’s going on, we have to first understand how leverage works in investing:
Let’s say that you had $10K in your brokerage account. You have a high-conviction stock that you think is going up and want to invest more than $10K in the said equity. You can take another $10K as a loan from your brokerage, staking your entire position as collateral.
Assume the stock went up 10% over the next month, and you exit the position.
This is the magic of leverage. You used a 2:1 leverage on your investment and doubled your return3.
What’s important to realize is that this works the other way, too — If the stock went down 10% and you had to exit the position, the 2:1 leverage would literally double your losses.
Having a large amount of leverage is like driving a car with a dagger on the steering wheel pointed at your heart. If you do that, you will be a better driver. There will be fewer accidents but when they happen, they will be fatal - Warren Buffett
While personally taking leverage, making sure the portfolio is rebalanced regularly, and not getting margin called is a messy process for an average investor, a simple way to get leverage is to use leveraged ETFs.
Understanding TQQQ (and other leveraged ETFs)
It’s vital to understand how TQQQ works — class action lawsuits were filed (and thrown out) because investors did not understand how leveraged ETFs are structured. Let’s take a quick look at the TQQQ fact sheet:
The fund is only trying to 3x the daily return of QQQ and not the long-term return.
To understand how the index gains and index volatility affect the total return, consider this — Let’s say you invested $100 into QQQ and TQQQ. On day 1, the index went up 10%. On day 2, the index went down 10%.
Here’s how both funds would have performed4.
Day 1:
Index (QQQ): 100 x (1 + 10%) = $110
3x Leveraged Index (TQQQ): 100 x (1 + 3 x 10%) = $130
Day 2:
Index (QQQ): 110 x (1 - 10%) = $99
3x Leveraged Index (TQQQ): 130 x (1 - 3 x 10%) = $91
Overall Return (after 2 days):
Index (QQQ): (99 - 100)/100 = -1%
3x Leveraged Index (TQQQ): (91 - 100)/100 = -9%
Intuitively, you would expect your 3x levered portfolio to go down only 3% when the underlying index went down 1%. But, the leveraged ETF’s actual return (-9%) is much worse than the expected return (-3%).
So, why did $10K invested in TQQQ in 2010 grow to $2.1M?
Here also, our intuition fails us due to the magic of compounding. If in the above example, the index went up 10% on Day 2 as well, then:
QQQ Index overall return: 100 x (1+10%) x (1+10%) = $121 (21% return)
TQQQ overall return: 100 x (1+ 3 x 10%) x (1 + 3 x 10%) = $169 (69% return > 3x the return of QQQ)
Extrapolate this trend over 14 years and you can see how the portfolio compounds. Nasdaq-100 delivered a CAGR of 19.34% over the past 14 years, while TQQQ achieved a staggering CAGR of 42%.
While 42% may appear to be just a bit more than double 19.34%, the key is that it represents double the return every single year5 over 14 years.
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Leveraged ETFs as a long-term investment
It’s rare that our opinion differs considerably from other investors that we look up to. The general consensus seems to be that leveraged ETFs are not a great choice for long-term investors6.
The biggest downside with leveraged ETFs is the extra risk you take. For example, if QQQ falls more than 33.3% in one day, all the TQQQ positions will be wiped out7. This has certainly happened with some levered ETFs — Credit Suisse had to close its Daily Inverse VIX Short Term ETN (XIV) after it lost 96.3% of its value in a single day.
But I think this is missing the forest for the trees.
No one is allocating 100% of their portfolio to levered ETFs8.
AQR Research shows us that leverage provides a better return than increasing the concentration of your portfolio. How?
What’s the optimum leverage? Also, should we be worried about the relatively high expense ratio?
With the presence of circuit breakers, the probability of a single-day drop of 33% in QQQ or a 50% drop in S&P 500 is extremely low9.
What if we make a hypothetical model for TQQQ performance during the dot-com bubble and Global Financial Crisis?
What are the odds that you will completely lose your investment?
Is now the right time to invest in leveraged ETFs?
Volatility drag — The real risk with geared ETFs
Finally, how did Buffett use leverage to earn Berkshire’s extraordinary returns?
Let’s dig in: