Leveraged ETFs Don’t Always Deliver

Leveraged and inverse ETFs appeal to speculative investors who want to go big, but they aren’t always what they seem.

Reviewed by: Jessica Ferringer
Edited by: Jessica Ferringer

Leveraged ETFs proved to be popular with investors last week, particularly those that offer amplified exposure to tech names that sold off in the beginning of the week.

As tech stocks fell throughout the week, money flowed into the ProShares UltraPro QQQ (TQQQ), which offers 300% exposure to the Nasdaq-100 Index. On the flip side, the ProShares UltraPro Short QQQ (SQQQ), which offers the opposite exposure of TQQQ, or -300% of the performance of the Nasdaq-100 Index, saw net outflows for the week.

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Table courtesy of FactSet

(For a larger view, click on the image above)

On a somewhat contradictory note, the Invesco QQQ Trust (QQQ) also saw outflows for the week. However, TQQQ’s inflows show that speculative investors seem to be banking on a recovery in the Nasdaq-100 Index.

Short-Term Play

Leveraged and inverse ETFs make sense as a short-term play—with extra emphasis on “short term” if they’re offering 3x exposures. If an investor has a strong conviction that the market will move up or down in the very near future—meaning days, not weeks—a leveraged ETF could work well.

However, investors should be aware of the risk of leveraged strategies if they are held over long time periods. These ETFs are designed to provide a multiple of daily index performance. That said, the pattern of returns can have a significant impact on the long-term returns of a leveraged ETF, which is why it is not recommended to hold these for longer periods of time.

As an example, let’s consider the trailing one-year performance of these three ETFs.

Over the trailing year, TQQQ has provided a little over 3x the exposure of QQQ. However, SQQQ has fallen by just over twice the amount of QQQ’s gain.

Volatility’s Effect

For segments of the market that tend to be more volatile and prone to big swings, leveraged ETFs are more likely to be off the mark when used over long time periods.

This is especially true in periods of market stress, such as we saw last spring.

In March 2020, all three of these ETFs notched negative returns. QQQ fell by 11.2% for the month, meaning that, at least on the surface, inverse exposure should have resulted in a gain. However, SQQQ fell by 5.9% during this time frame. And TQQQ was down by over four times as much.

Longer Time Frames Mean More Risk

The example is reinforced when we extend the time frame to include April 2020.

Over this time period, QQQ had recovered from its decline, gaining 3.6%.

However, in spite of the base exposure’s positive return, both TQQQ and SQQQ were significantly negative. TQQQ had fallen by 17.5%, meaning that instead of providing 3x to the base index, it was actually 5x inverse performance. And SQQQ was providing over 12x inverse performance to QQQ.

That’s largely because of the daily reset feature of the ETFs, which delivers 3x or -3x the returns of the relevant index on any given day, rather than the week or the month. A highly volatile market can complicate matters even more.

Expensive Exposure

Along with the risk of performance not being in line with expectations, leveraged ETFs also command a higher management fee to accommodate the expense of leveraging and actively rebalancing their funds. While cost is unlikely to be a factor in the selection process for leveraged ETFs, it is still a factor that contributes to the erosion of performance over time.

Relative to its vanilla counterpart, TQQQ is nearly five times as expensive.

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Table courtesy of FactSet

(For a larger view, click on the image above)

SQQQ has the same expense ratio as TQQQ. Though the fund holds over $1.74 billion in assets under management, its lower trading volume means the spread is higher than that of QQQ and TQQQ.

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Table courtesy of FactSet

(For a larger view, click on the image above)

Buyer Beware

Investors who purchase leveraged ETFs should be fully aware that if these funds are held for longer than a few days, they might not be getting the exposure they expect—both directionally and in magnitude.

In spite of the risks, these types of funds retain their appeal. At a basic level, leveraged funds provide the potential for higher gains if one correctly predicts the way the market will move over the next few days.

But as with anything in the investing world, this promise of higher reward also comes with a higher level of risk. If the market moves against you (and sometimes even if it doesn’t), investors can get burned.

Contact Jessica Ferringer at [email protected] or follow her on Twitter

Jessica Ferringer, CFA, is a writer and analyst for etf.com. She has 10 years of experience in investment research and due diligence, including helping to manage ETF portfolios. Jessica has a bachelor’s degree in economics from Lafayette College and an MBA from the University of Pittsburgh.