[This article appears in our February 2021 issue of ETF Report.]
There’s a certain amount of mystery around who’s investing in any ETF, but even more so with inverse and leveraged ETFs.
These funds have huge levels of trading volume relative to their size within the ETF market. Consider that, as of mid-January, the $1.5 billion ProShares UltraPro Short QQQ ETF (SQQQ) was second only to the $333.5 billion SPDR S&P 500 ETF Trust (SPY) in terms of 45-day average daily share volume.
Further, even though these funds represent about 1% of all U.S.-listed ETF assets, 15 of them are among the top 50 ETFs with regard to average daily share volume.
Leveraged and inverse ETFs are trading tools more than anything else. However, there are many ways to use them—and some can be quite surprising, and maybe even a little dangerous.
The vast majority of leveraged and inverse ETF users do appear to be traders, what with the funds’ outsized volumes and turnover. They can also be used as a way to enhance returns or as a hedging vehicle or risk management tool.
Direxion, the No. 2 issuer of leveraged and inverse ETFs, has 60 such funds holding $19.3 billion in assets under management (AUM). Its customer base for the products is two-thirds your “classic active trader” and one-third “tactically oriented financial advisors, RIAs and hedge funds,” conjectures its president Rob Nestor.
Meanwhile, ProShares, the first issuer to roll out leveraged and inverse ETFs, has nearly $36 billion in AUM in these funds. These investors include mainly “financial professionals and other knowledgeable investors,” according to CEO Michael Sapir.
Nestor asserts that the flows around leveraged and inverse funds are indicative of a sophisticated investor base.
“The leveraged and inverse business has a very different flow profile than the rest of the ETF business. As is typical in most areas of investment management, people tend to chase performance. Beyond core exposures, the highest-flow products are those with the highest returns, and vice versa,” he explained. “It’s exactly opposite in leveraged and inverse—it’s highly countercyclical. Most of the redemption activity is in the highest-performing products. All the evidence indicates, in aggregate, that people understand them.”
Both Direxion and ProShares have plowed massive amounts of money and hours into providing education around the leveraged and inverse products they offer regarding how they work, in the interests of ensuring that investors understand the ins and outs of them and that they’re more likely to have a good experience with the products.
Matthew Tuttle, CEO and chief investment officer of Tuttle Tactical Management, an advisory firm and asset manager associated with six different ETFs, says that when managing portfolios, his firm views assets as being either short or long volatility.
“Anything on the equity side is short volatility—it does better when volatility is going down, and does worse when volatility is going up. We want to always have some sort of counterbalance that’s long volatility,” he said, noting that his firm uses inverse ETFs as part of its long-volatility sleeve.
Among the leveraged and inverse ETFs he uses in his portfolios regularly are the ProShares Short QQQ (PSQ), the Direxion Daily 20+ Year Treasury Bull 3X Shares (TMF), the Direxion Daily S&P 500 Bull 3X Shares (SPXL) and the ProShares UltraPro QQQ (TQQQ).
“We’ve got tactical models that will move us into inverse ETFs when or if the market starts going back down,” Tuttle noted. “It’s a really effective way to get inverse exposure, and it’s easier than selling stuff short.” He further points out that, with such products, there are no worries about borrowing or prime brokers.
But his firm doesn’t just use them as a risk management tool. Leveraged ETFs especially can be used to magnify exposures.
“The beauty of leveraged ETFs as a whole is that they allow you—as long as you know what you’re doing—to gain access to things like Treasuries or all the different equity markets, while using less capital,” Tuttle elaborated. “I can take 30% of our portfolio and put it into things that will do well as volatility is increasing. But if I want the remaining 70% of my portfolio to have more than 70% equity exposure, that’s where levered ETFs can do a really good job.”
He notes that the holding periods really depend on the markets, but are typically shorter term—as in anything from a few days to a few weeks, but can range widely. Tuttle believes the next market crash will resemble more what we saw in March 2020, which necessitated shorter holding periods.
‘Volatility Drag’ Can Impact Returns
“If you really want to understand volatility drag, look at 3x levered inverse funds and how they did in March, and you’ll be shocked,” said Tuttle. “Most—if not all—were down in March when the market was down around 15%. You’re thinking it should be up 45% and it’s actually down.” (To see the effects of volatility-drag laid out visually, see the charts on pages 20-21.)
“Because of the volatility-drag on anything levered, typically we’re going to have short-term holding periods,” he added. “Assuming that bear markets going forward look more like February and March than they do 2008, I assume our holding period would remain fairly short.”
While Tuttle says he typically holds 10% in Treasuries, he doesn’t think that’s enough protection, nor does he think the traditional 60/40 portfolio allocation provides enough either. That’s where inverse ETFs come in.
“The only thing out there that’s guaranteed to go up when the market goes down is an inverse ETF,” he said.
Hedge Fund Tool
Coe Magruder is the founder and CEO of Washington Growth Strategies, an RIA firm. And since 2014, he’s also run his own hedge fund, the Washington Growth Fund, in which he’s the largest shareholder. The hedge fund relies heavily on leveraged equity ETFs, though Magruder says he doesn’t really use inverse funds. Notably, he does use regular long ETFs for his advisory clients and no leveraged products.
However, Magruder’s hedge fund has recorded outsized returns, up 43.88% in 2019 and up 47.18% in 2020 on net.
“I’m big on earnings growth, GDP growth—if it looks like it’s going to grow at an accelerated rate, then that’s something I start positioning myself to look to buy,” he said.
“I use the leverage when I see strong momentum. I try to stay with it as long as I can; I’m not a big trader—meaning, I’d like to hold it over a year,” Magruder added. “But when I see something coming, I know I need to get out of the way.”
Indeed, he maintained a market position in the ProShares Ultra S&P 500 (SSO) from after the 2008 Financial Crisis crash, entering the fund in 2009, through February 2020, when spiking volatility drove him into a 100% cash position shortly before the March crash. You read that right: He held on to a 2x ETF for more than a decade and came out of it OK—great, even.
“I’m looking for any hiccup that would tell me to run for shelter. You can’t buy this stuff and walk away,” Magruder said.
However, he almost immediately started phasing SSO back in to his port-folio after the March chaos.
Right now, the hedge fund holds a 45% position in SSO, with the Direxion Daily Small Cap Bull 3x Shares (TNA) claiming a 19.8% weighting, and the Direxion Daily MSCI Emerging Markets Bull 3x Shares (EDC) at 11.5%. Magruder believes signs point to positive things ahead for small caps and emerging markets, but thinks technology is a bit overbought and facing head winds, so he’s phasing out of TQQQ.
All In On Leverage
David Kreinces is the founder and chief investment officer of ETF Portfolio Management, which specializes in trend following and risk parity, and takes a bold approach with leveraged ETFs in its portfolio. While the firm eschews leveraged and inverse products tied to narrower indexes, it embraces those that cover broad and core asset classes.
“When you see what the extreme volatility does to the distortion of the returns, you see that the more volatility, the more the distortion,” he said. “When you’re dealing with the larger asset classes or the stronger uptrends, the distortion is less of an issue.”
Like Magruder, Kreinces takes a long-term view of these asset classes, and notes that while the ProShares UltraPro S&P500 (UPRO) had a frustrating year in 2020, both TQQQ and UPRO have delivered much better returns over the last 10 years relative to their unleveraged counterparts.
Splitting Time Between TQQQ & TMF
Kreinces’ firm uses a benchmark for many of its clients that usually splits itself evenly between TQQQ and TMF, with a 6% carveout for bitcoin in the form of the Grayscale Bitcoin Trust (GBTC).
However, certain allocations can be “turned off” as a form of risk control, and when interviewed, he said that was the current case with the TMF allocation. However, if volatility increases, the allocation to TQQQ could be reduced.
“I think it’s hard to remember sometimes, when momentum is in your favor, how fast it can turn. Investors like to say that the market takes the escalator up and the elevator down,” Kreinces noted.
He’s very clear that these are products that can quickly turn ugly, but also points out that investors can “tiptoe” into them by adding them in small increments to a portfolio.
While these products definitely have their devotees, all of those investors are very clear that they watch both their geared holdings and the wider markets closely. Good outcomes depend largely on capturing the strongest trends and knowing when to exit a position.
FactSet Senior ETF analyst Lois Gregson notes that even sophisticated investors can be confused by these products, mentioning that, in the course of her career, the CEOs of at least two brokerages have requested her help to understand how they work.
She recommends that if investors decide to venture into a leveraged or inverse ETF, they should write down why they’re in it, and if that reasoning changes, to simply get out of the position.
“It may trade like a stock. It doesn’t behave like a stock. More than likely, it’s not going to come back to you. You need to cut your loss and get out,” Gregson said. “It’s OK to be wrong. It’s not OK to stay wrong.”