Pricing Of Leveraged ETF Decay - Part 2
Summary
- Leverage has been used by financiers to make fortunes in Private Equity, Hedge Fund Management and Investment Banking - particularly where they are able to control the narrative.
- Wholesale (inexpensive) financial leverage has historically (until recently) mostly been out of reach of retail investors. LETFs and availability long dated options now allow retail investors access to financial leverage.
- But misapplied or misunderstood leverage can go horribly wrong and amplify losses.
- Leveraged ETF Decay costs (including interest costs) are at all-time lows, which can support an LETF "positive gearing effect."
- But investors should be prepared for a spike in LETF decay costs (in multiples). Investors should also understand that some LETFs leak (decay) a lot more than others.
sharply_done/E+ via Getty Images
This article seeks to further analyze decay pattern correlations between Long and Short Leveraged ETFS (LETFs); to briefly explore the relationship between various leading LETFs; to analyze cost relationships between 2X and 3X LETFs over time, and over various market conditions; to analyze how LETF's decay patterns move in relation to one another over time (do decay patterns appear to correlate?); to look at how Decay patterns move in relation to volatility over time; to look at how hedging costs and difficulty in hedging (illiquidity in underlying hedging instruments and Swaps) appear to impact decay pricing, and to consider how decay costs appear to bear practically zero relationship to disclosed expense ratios per the prospectuses, or to decay calculations which to not take into account compounding (or to volatility models). Lastly, to look at macro-economic inputs into Leveraged ETFS as a possible longer-term investment for a small "at risk" portion of investor's portfolio.
LETFs should only be used for short term investors or those conclusively bullish on the Nasdaq 100 or S&P 500 or other underlying indices, and for investors seeking to take advantage of the low gearing costs imbedded in LETFs ("positive gearing effect").
This article continues on the LETF assumptions and findings per my initial ProShares UltraPro QQQ (NASDAQ:TQQQ) article: "Pricing Of Leveraged ETF Decay: A Different Approach." I strongly suggest that readers read and review that article first as I do not want to repeat my LETF hedging analysis and the math basis for the LETF Decay calculations, and a lot of the following will not make much sense without the background of the previous article.
Are LETF returns likely to outrun their holding costs?
The key LETF investment question is whether LETF decay costs are likely to continue to be covered by the LETF "positive gearing effect." In this analysis it is important to understand that not all LETFs decay at the same rate.
The Problem
In my previous article, I suggested bond-type bootstrapping techniques be used to isolate LETF decay. The underlying principles behind the polynomial method as the basis of calculation for the following charts is hopefully explained in my precursor article "Pricing of LETF Decay" and in the Annexures to that article. Decay costs are difficult to correctly isolate and furthermore decay costs are masked by the difficulty in visually comparing and conceptualizing exponential LETFs performance relative to their underlying indices' performance. (Simple visual stock chart type comparison is not possible). LETF prospectuses citing LETF examples which ignore compounding (incorrect math) have exacerbated the misunderstanding of the decay pricing problem. Now that we have been able to correctly isolate LETF decay costs over time (by first isolating the effects of compounding), LETFs can be compared to one another over time, and several observations become evident which will hopefully provide investors with useful information regarding their LETF investment / hedging decisions and investment periods.
Figure 1: Leveraged ETF "decay" or "leakage" relative to the underlying index 2013 to date. (Model source: Author, Data source Yahoo.com, Investing.com, Excel 365 Stock History function)
3X LETF data analysis:
- ProShares UltraPro QQQ 3X TQQQ
- Direxion Daily Semiconductor Bull 3x (SOXL)
- Direxion Daily S&P 500 Bull 3X (SPXL)
- ProShares UltraPro S&P500 (UPRO)
- ProShares UltraPro Short QQQ (SQQQ)
- Direxion Daily Small Cap Bull 3X (TNA)
- ProShares UltraPro Short S&P500 (SPXU)
2X LETF data analysis:
Observations from the Decay Charts in Figures 1 and 2:
Both Long and Short LETF decay rates appear to move in tandem over time
Both Long and Short LETFs follow remarkably similar Decay patterns over time. (The consistency of various LETF decay movements over time relative to their peers is obvious from the consistent patterns in the longer term chart below). A further observation from the chart below is that LETF decay prices can increase and decrease in multiples under certain market conditions (consistent (but in inverse proportion) to the roller-coaster price movements of the LETFs). It also evident that the costs of hedging LETFs can increase dramatically under adverse market conditions (e.g., March 2020).
Decay costs are highly volatile
Decay costs (expressed as a percentage of the LETF price) are highly volatile, moving from below 5% decay cost at present, up to 30% - 60% in distressed market conditions. Explained another way: 30-60% of post March 2020 returns were consumed by LETF Decay costs before the LETF broke even to pre March 2020 levels (whereas a direct investment into the index obviously incurred zero decay costs. After March 2020, unleveraged ETFs e.g. QQQ broke even a lot quicker than their leveraged counterparts (e.g. TQQQ)
3X LETFs are significantly more expensive than 2X LETFs
Please note that the 3X LETFs are referenced to the left-hand scale (max 60% annual LETF decay) of Figure 1 above whereas 2X LETFs are referenced on the right hand scale (max 14% decay per year) in Figure 1 above. When scaled above, 3X LETF incur decay costs of roughly 2.5 times that of their 2X counter-parts with the same underlying index. (You are paying 2.5 times more in "decay leakage" for a 3X LETF than a 2X LETF.)
3X LETFs (with a 66% leverage ratio) show decay rates of roughly 2.5 times the decay rates of 2x LETFs (with 50% leverage ratio). You are paying away 2.5 times the decay cost for 16.7% more leverage. (This might be because the gearing to collateralization ratios of 3X LETFs (2:1) are double those of 2X LETFs (1:1), and ^3X LETF Swaps (in the absence of any external credit support) are sailing very much closer to their collateral default levels: 3X are much closer to being under-water or under-collateralized than 2X in the event of a March 2020 type market down-turn. For this reason, 2X LETFs appear to fare better than 3X LETFs in distressed market conditions.
Conclusion: If you have capital to spare then consider investing $150 into 2X LETFs (instead of $100 into 3X LETFs) for the same amount of leverage / synthetic borrowing. You will suffer less decay and your investment will fare better in a market downturn (compared to a 3X investment).
Obviously, if you simply invest in the 1X underlying index QQQ or VOO you will not be exposed to any leakage or the hidden embedded costs of LETFs whatsoever. This is certainly a preferred strategy should we expect a sideways market (but then you are foregoing the possible benefits of leveraging turbo-charged returns in a bull market).
Difficulty (illiquidity) in hedging the underlying Index appears to materially impact Decay pricing:
LETFs which track less liquid indexes (e.g., semiconductors, gold, oil LETFs) incur multiples higher decay costs compared to mainstream S&P and Nasdaq LETFs. Hedging and Swap contracts are more liquid and easily traded on S&P and Nasdaq LETFs.
Conclusion : Semi-conductors, Gold and Oil LETFs incur significantly higher decay costs/leakage than S&P500 and Nasdaq 100 LETFs. Semi-conductors, Gold and Oil LETFs are probably not appropriate as long-term investment tools because decay/leakage costs will probably outweigh the "positive gearing effect" in the long term.
Figure 2: Leveraged ETF "decay" or "leakage" relative to the underlying index November 2020 to date. (Model source: Author, Data source Yahoo.com, Investing.com, Excel 365 Stock History function)
Short LETFs incur decay costs of 2 or 3 times their Long LETF counterparts:
From Figures 1 and 2 above:
- ProShares UltraPro Short QQQ ETF SQQQ 3X has roughly twice the decay of its Long Counterpart : ProShares UltraPro 3X TQQQ and
- ProShares UltraPro Short S&P500 3x SPXU decay is approximately 3 to 4 times that of its long counterpart ProShares UltraPro S&P500 3x UPRO
Conclusion: Short LETFs are significantly more expensive than Long LETFs. Short LETFs costs exceed their positive gearing effect , and appear unsuitable for longer term investments and should be used only for short term hedging.
Holding short LETFs for protracted periods also suggests that you are betting against future (inflationary) asset price increases which is certainly not a long term position that I would support.
Suggestion: To short the index rather sell TQQQ than buy SQQQ; that way, you will save decay costs in the order of magnitude of ~3 times.
(I submit that all of these observations are not possible from visual comparison of traditional LETF price charts , or without proper isolation of the decay component ("decay strips" per the charts above in Figures 1 and 2 ).)
Decay costs proportionately decrease as LETF prices increase (and vice versa):
From Jan. 29, 2021, to Feb. 12, 2021, TQQQ prices increased 20% while TQQQ decay costs decreased by 20%. Other LETFs prices and decay costs also moved in a similar way in lockstep. LETF costs (comprising predominantly Swap costs) appear to remain relatively fixed in the short term so an increase in the index of 20% would appear to directly dilute Decay costs to that extent in the short term.
Conclusion: Because LETF prices have run so hard in recent months, the legacy fixed (5-year) Swap costs appear to be spread or absorbed over a much increased LETF asset base, and LETF decay or leakage costs (as a percentage of LETF AUM) are consequently at an all time low. In March 2020, the opposite held true. LETF asset values plummeted, and LETF costs (as a percentage of LETF AUM) sky-rocketed in multiples.
Decay costs do not always increase in relation to volatility increases:
It is interesting to note that over that same period Jan. 29, 2021, to Feb. 12, 2021, Volatility CBOE (VIX) doubled to 37.21 but this increase in volatility was not associated with an increase in Decay costs. In fact, decay costs declined by 20%. We might have expected decay costs to increase with increase in volatility (as suggested by various "volatility decay" academic papers). The Decay cost (expressed as a percentage of AUM) drop of roughly 20% appears to be driven by a 20% increase in the underlying asset base and not by volatility. Decay costs did not move in relation to the 100% increase in volatility.
From 19 February 2020 to 23 March 2020 NASDAQ-100 Volatility Index (VOLQ) increased five fold from 15% to 60%, but this volatility spike had practically zero impact on daily decay costs until after 23 March 2020.
With reference to my previous Pricing of LETF Decay article: The TQQQ vs. QQQ variance analysis model below sheds more light: The green variance cells comparing QQQ^3 to actual TQQQ show that on certain days in March 2020 TQQQ outperformed its 3x return objective during the crash and that daily Decay levels were at very low levels for most of the precipitous drop in March 2020. Only at the very bottom of the dip did daily Decay costs spike by which time the market was turning and these costs were absorbed by TQQQ's equally stratospheric recovery.
Figure 3: Daily TQQQ vs QQQ variance analysis (Model Source: Author (ref Annexure A), Data source: Yahoo, Investing.com, Excel 365 Stocks function)
This is useful information for investors: TQQQ did not crash nearly as badly as expected per the ProShares volatility chart. Put another way: If TQQQ had crashed by ProShares volatility calculations projected at 88% (instead of actual 66.5%), then the TQQQ price would have dropped from $59.03 on 19 February 2020 to $7.08 (instead of $17.81 actual) on 23 March 2020, and applying actual subsequent growth and actual subsequent decay factors (applying path dependency), the current price of TQQQ would now be $60 (instead of $150).
Conclusion: The ProShares volatility model is indicative only and can be materially inaccurate.
Conclusion: Decay costs do not always increase with increases in volatility.
A further observation/inference regarding volatility
Decay costs (expressed as a percentage of, e.g., TQQQ price) will increase in declining markets. Declining markets are usually associated with increases in volatility. As a consequence, volatility has (mistakenly in my view) been associated as a driver for the increase in LETF decay costs. This incorrect assumption is clearly evident in market conditions where increasing prices are accompanied with increasing volatility and yet Decay costs decrease.
From Feb. 19, 2020, to March 16, 2020, saw increasing LETF values accompanied with increasing volatility: Surprisingly (and contrary to Volatility decay pricing models), Decay costs reduced (volatility models would have priced an increase in decay costs). Refer "Pricing of LETF Decay - Part 1" Volatility section for detailed analysis of this period.
Between Feb. 12, 2021, to March 8, 2021, saw a market decline of all indices (Nasdaq was 7.5% down) and LETF prices and AUM showed amplified declines. The ratio of (fixed) decay costs relative to (diminished) LETF values appeared to be the cause of higher decay ratios (relative to the underlying index) across all LETFs during/after this period until June 2021, which would appear to corroborate the above findings.
Conclusion: LETF Decay or leakage appear to contain a fixed overhead component (possibly comprising relatively fixed long term Swap costs) which are absorbed by LETF investors over subsequent periods (LETF Decay cost "lag"). In March 2020 (when TQQQ price dropped to $17), the annualized TQQQ Decay costs were ~35% pa. Now that TQQQ price is around $170, the annualized TQQQ Decay costs have dropped ~3.5% pa). Decay costs appear to move in direct (inverse) proportion to asset prices. Per Figure 3 above, daily decay costs do not move in direct proportion to volatility.
The Volatility chart in Figure 2 does not appear to correlate to the Decay scatter-plots ("Decay Strips")
Volatility does not appear to play as big a role in LETF Decay pricing as I initially anticipated (Swap costs and other fixed costs appear to play a more significant role): The scatter-plot charts do not appear to hold any close relationship or correlate to the solid pink Volatility VIX chart above. I looked at this volatility disconnect in a lot more detail in my previous article: Pricing ETF Decay.
European LETFs
Per figures 1 and 2 above all American LETF move in tandem. i.e. all US LETFs appear to move in a very chart similar pattern to one another . European LETFs however do not appear to track US LETFs with the same consistency. The Blue Chart below reflects the WisdomTree European LETF (3QQQ) whose decay costs over time do not seem to correlate as closely to the TQQQ (US) decay costs as other US ETFs. This may be due to time zone differences leading to difficulties in hedging US indices, or to different hedging strategies by different issuers, or perhaps other unknown factors?
Figure 4: Comparing US ProShares TQQQ decay to UK WisdomTree 3QQQ decay (Model source: Author, Data source: Yahoo.com, Investing.com, Excel 365 Stock History function)
Compounding, Compounding errors in Decay analysis, and "beta decay"
Referring to the downloadable Excel model in Figure 5 below: Compounding plays a considerable part in LETF decay for analysis periods greater than one day.
Decay models that ignore compounding and do not factor out the effects of compounding will materially misstate decay. Compounding exponentially impacts high growth LETFs (where compounding is more pronounced) more than low growth LETFs. You will observe from Figure 5 that compounding has very little impact on pricing for very low interest rates.
The effects of compounding are exponential (non-linear) for higher growth rates and for longer periods. The takeaway is that analysis without factoring out the effects of compounding is materially misstated and not comparable:
- Between different issuers/different LETFs with different growth rates
- Over different market low growth/high growth/negative return market cycles
- Over different time scales
The Polynomial method (using exponents to factor out the effects of compounding) is used in most academic LETF papers and the correct method to use in calculating decay. The simple 3x method results in in inclusion of mathematical compounding errors in decay calculations for analysis periods longer than 1 day. These compounding errors are sometimes referred to as "beta decay" These tracking errors are well illustrated in the various LETF prospectuses to illustrate "beta decay." (Unfortunately, the issuers only give examples of the wrong 3X math to illustrate that LETFs do not track their underlying indices for more than one day, and oddly don't show us how to solve the decay problem. These bad prospectus examples have propagated much incorrect decay analysis, and masked the true cost of decay.)
The Polynomial method is able to achieve 100% correlation to the underlying index for long term price movements whereas other methods don't correlate (or I haven't been able to get any other methods to correlate). The reasons and methods are hopefully explained in my previous article Pricing of LETF Decay, and Annexures.
Bootstrapping the "Decay Strip"
In a nutshell, (but without getting into too much complexity) the method solving decay is very similar to the theory of fixed income bond or yield curve bootstrapping - i.e., bootstrapping the risk free yield curve to isolate and strip out coupons and to derive a zero coupon curve. Save that for LETFs we are substituting the underlying index price movements (e.g., QQQ price movements) for the risk free government bond or yield curve, and applying a ^2 or ^3 exponent to that index. We then back-solve (bootstrap) the decay exponent factor (using the LOG function), deriving a "decay-weighted" index curve (similar, akin to a yield curve) and then strip out the decay component ("decay-strip") (similar to a bond coupon strip, or yield curve strip to derive the forward or zero interest rate curve). The decay models and methods used to build these are contained in the annexures to my previous article "Pricing of leveraged ETF Decay."
This isolated "decay strip" then provides useful and comparable information for investors. This method yields remarkably different results to widely used methods (propagated (masked/hidden?) by incorrect examples in LETF prospectuses) that do not involve polynomials and compounding. I submit that, in the same way that there is only one correct way to mathematically derive a forward or zero curve from a yield curve, there is only one correct way to derive LETF decay over time. Save that for LETFs the compounding effects are supercharged by very high growth rates (compared to bonds). As in the bond market, the basis of comparison, the basis for annualization of rates and compounding periods become very important in comparing LETFs (save for LETFs, comparison errors become supercharged and diverge from the correct basis far more quickly due to very high rates of return and exponentially higher compounding effects).
Frequency of compounding
The following frequency of compounding model will hopefully illustrate the significant effects of LETF compounding and also calculate comparable rates between different compounding periods. The model provides the polynomial formulae (in the yellow cells and in the footnotes) which form the basis of allowing us to get decay-weighted LETF price movement data to correlate to the underlying indices (both on a day-to-day-price movement and a 252-day price movement basis). High correlation means high confidence that the modeling and math works: that the LETF data (adjusted for the decay variance charts above) properly tracks its underlying index.
Figure 5: Frequency of Compounding Model (formulas are available by downloading the model. (Model source: Author)
Some Quick notes of the modeling requirements:
- 100% correlation requirement between the underlying index, and the decay-weighted LETF (both on a daily-price-movement, and a 365-day-price movement basis.
- Comparability: Compounding period/frequency must be equal for comparison. (The charts above all use nominal annualized compounded quarterly, or NACQ, compounding.)
- Comparability of Decay data between different time periods, different Issuers, different LETFs, comparability between long and short ETFs. (requires elimination of any compounding effects)
- The method solving decay is very similar to the theory of fixed income bootstrapping - i.e., bootstrapping the risk-free yield curve to isolate and derive a zero coupon curve, save that we're assuming that the underlying index price movements (e.g., QQQ price movements) for the risk free interest rate curve.
LETF Decay Conclusions (ranked in ascending order and risk of Decay costs):
- S&P500 LETFs currently offer very low (very attractive) Decay leakages of currently ~1% per year for the 2X S&P500 SSO and ~3.5% per year leakage on your 3X S&P500 UPRO investment. So if you are bullish on the S&P 500 then these to LETFs offer gearing at a very low cost at the moment (but please always remember that these costs can sky-rocket and you could pay away up to 30% - 60% of your investment in decay costs in times of distress). Disclosed LETF expense ratios of ~1% per year become meaningless for investment decision making purposes within the context of total decay costs over time.
- 3X LETFs are significantly more expensive than 2X LETFs. (as a rule of thumb: 67% gearing will cost you 2.5 times more than 50% gearing)
- Nasdaq 100 LETFs also offer relatively low decay leakages of ~2.5% for 2X QLD and ~7% for ^3X TQQQ. So if you are bullish on Nasdaq 100 and FAANG, then these TQQQ and QLD LETFs offer relative low gearing costs at the moment (relative to e.g. a 2/3rds TQQQ purchase on overnight margin).
- But Nasdaq LETFs leak more than S&P 500 LETFs (possibly due to their higher hedging costs (possibly associated with lower volumes and liquidity relative to S&P500 LETFs)).
- Short S&P500 LETFs are the next in line on the LETF cost scale. 2X Short SP500 SDS currently leak 6.772% relative to your SDS investment per year, and 3X short SP00 SPXU currently leaks 11.7% of your SPXU investment relative to the underlying index per year.
- Short Nasdaq LETFs are also more expensive in leakage terms than their S&P 500 counter-parts.
- Most expensive are then the (relatively illiquid) Long Semiconductor, Oil, Financial, LETFs referenced to lower volume, lower liquidity (more costly to hedge) indices.
- Short LETFs on these illiquid indices will, in turn, be significantly more costly than their Long Counterparts.
Please bear in mind that in times of distress, banks tend to withdraw from the Swap market and that less credible LETF issuers may be forced into bankruptcy along with your LETF investment. Moreover, even with the most credible of issuers and liquid S&P500 and Nasdaq indices, up to 60% of your LETF value may be consumed by LETF decay/leakage in times of market distress. Much higher leakages to be expected for Short LETFs and (relatively) less liquid or less easily hedged indices. Banks can, and are likely to withdraw from the OTC Swap market in times of distress rendering the hedging of LETFs difficult/costly, which is likely to result in a disconnect in LETF tracking of the underlying index in times of market distress.
So in summary: Leverage afforded by LETFs is relatively inexpensive at the moment, but can become very expensive very quickly in times of market distress during which time it becomes difficult and costly to realize hedging losses. Short and difficult hedge (expensive to hedge) LETFs are (relatively) more expensive to hedge than the more liquid S&P 500 and Nasdaq 100 indices (and the Decay costs for these more esoteric LETFs are likely to exceed the long term positive gearing effects). Best to follow the prospectus advice and avoid using fringe LETFs as longer them investments.
Macroeconomic factors that have strongly influenced recent LETF pricing and returns
As per the Financial Times: "Despite the Feds 'hawkish' (i.e., tightening of monetary policy) initiatives, US Stocks remain buoyant at record-high levels while yields on US treasuries remain stubbornly low compared with historic norms."
Stimulus
It is no secret that governments have been buying bonds in spectacular quantities in terms of QE stimulus initiatives: the following chart measures the Fed's bond purchases (thereby injecting stimulatory cash into the financial system, driving share prices).
Figure 6: The Fed's balance sheet has swelled to all time highs. (Source: Federal Reserve, Bloomberg, FT)
This massive injection of cash into the financial system has kept interest rates artificially low, and considerably reduced the cost of synthetic debt underpinning the Total Return Equity Swaps that are used to hedge LETFs. Interest rates are expected to stay low in the 1.4% to 2.1% range through 2024, despite inflation. There is an extraordinary and unprecedented amount of cash sloshing around the global financial system, and companies are finding it very easy to raise capital in terms of IPOs and corporate debt issuances.
Loose money supply hangover will continue through 2024
The Goldman Sachs "financial conditions" index (which measures the looseness/tightness of cash supply is at an all time low indicating "looseness" or excess monetary supply (M2) and supporting. This flood of cash (in my understanding) needs to dry up before the Fed is able to meaningfully tackle inflation through interest rates.
Figure 7: "Looseness" (oversupply) of money at an all time high. (Source: Goldman Sachs, Bloomberg, FT)
Conclusion/Inference (with reference to LETFs): Interest rates are expected to stay low in the 1.4% to 2.1% range through 2024, despite inflation, which is good news for leveraged ETFs and their significant synthetic borrowings embedded in the Total return Equity SWAPS. Such SWAPS make up the overwhelming majority of the assets and hedges and balance sheet underpinning LETFs.
Quantitative Easing has also had a remarkably positive impact on asset and equity prices. Seeking Alpha author Lyn Alden Schwartzer writes some really outstanding SA articles on inflation and summarizes her proposed inflation hedge as follows:
Figure 8: Seeking Alpha author Lyn Alden Schwartzer writes on inflation (Source: Seeking Alpha, Lyn Schwartzer)
The following articles on inflation by Lyn Alden Schwartzer are well worth a read:
- "3 Types Of Inflation, And How They Impact Your Portfolio"
- "Investing With Inflation: 150 Years Of Data"
- "QE, Wealth Concentration, And Political Risk"
Equity and interest rate prospects (as they impact LETFs)
Let's have a look at long term equity growth prospects, the significance of market corrections in the long term and attempts to profit from market timing.
First, I would like to look at the very long term returns on stock markets and debt markets. Please look at the history of return per the chart in Figure 9 below. And in particular please observe the relative returns of stock Indexes vs the cost of bonds. Applied to LETFS the outperformance of stocks vs the cost of debt has resulted in a "positive gearing effect" on LETFs, and, for long term investors, this positive gearing effect has persisted for nearly 100 years:
Figure 9: 100 year returns on equities vs bonds vs T-Bills vs Inflation (Source: Robert Shiller's book, Irrational Exuberance, Robert Shiller's Yale University Online Dataset, U.S. Bureau of Labor Statistics.)
Please also note that the Y axis in the chart above is Log Scale (which has the effect of flattening stock price increases: Normal scale stock prices would appear exponentially higher).
The chart in Figure 9 shows that $1 of small cap equities have grown to $ 25 617 (twenty five thousand times growth!) over 94 years. The compounded growth factor is surprisingly small at 11.4% per year: [(25617^(1/94)-1=11.4%], while Large caps grew at 10.2% and long term government bonds at 5.6% per year. We can therefore conclude that a long term positive gearing effect of roughly 6% [say 11% equity return less say 5% interest cost] per year has, on logarithmic average, existed for the last 94 years. Looking forward, interest rates are projected to remain in the 1.4% to 2.1% range through 2024, which is well below the 5% historic interest cost average, which (in my personal outlook) would tend to increase the positive gearing effect of LETFs to roughly 8% in the near term (provided equities continue to perform).
Smooth long-term stock returns
Please also observe that in the very long term that the above charts in Figure 1 appear remarkably smooth: market downturns tend to get ironed out and disappear into complete insignificance in the long run. This long term smoothness supports the old adage, "it's not about timing the market, but about time in the market," has been proven true over the years. Research shows that those who stay invested over the long run in a well-diversified portfolio will generally do better than those who try to profit from turning points in the market.
Figure 10: "Time in the Market" beats "Timing the Market" (Source: Johnson Investment (I presume that the S&P returns quoted above exclude dividends)
Using equities to hedge against inflation
Please also observe your likely loss of wealth by investing in bonds instead of stocks over the last 95 years (and compare this risk to the relatively smooth and directional trajectories of the stock charts over time). A $1 investment into bonds would have returned $175 whereas a $1 investment into small cap stocks would have returned $25 600.
Conclusion/Inference: Long term inflationary risk far outweighs market timing and market volatility risk: From a Behavioral Finance perspective clients tend to fixate on short term market timing and are concerned about getting timing wrong and consequently tend to remain in cash for far too long under the incorrect short term assumption that they are being conservative and mitigating volatility and risk (when, in so doing, they are, in fact unintentionally exposing themselves to far greater inflationary risks).
Conclusion (my personal perspective/inference): Over time the risk of not keeping up with (inflationary) real asset (stock) price increases far outweighs the benefits of attempts to "time the market" by holding and remaining in seemingly stable bonds and cash. In the long term, inflationary risks by far outweigh the risks of trying to time favorable entry into the market.
Stimulatory initiatives (Fed bond buying program):
I think that we can all agree that stimulus bodes well for the economy and for the Fed and for politicians. We have seen massive stimulus - essentially and oversupply of money - i.e., M2 (and monetary inflation is now a reality) as a consequence of the various stimulatory initiatives. From my perspective this flooding of the market with money has had 2 significantly positive impacts on LETFs: Borrowing rates have been held very low - artificially low (which makes the cost of synthetic leverage underpinning LETFs very low), and secondly a lot of this money over-supply has found its way to Wall Street stimulating stock prices (and not necessarily into workers pockets). Both of these factors have further contributed to the "positive gearing effect " for LETFs (which react to these factors in multiples). Simply put: the turbo-charged returns on Nasdaq 100 and S&P500 have far outweighed the costs of holding LETFs, and LETFs have further provided an amplification (in multiples) of this positive gearing phenomenon, which has manifested in ten fold increases in TQQQ LETFs since March 2020.
Conclusion: My outlook is that long term equity returns will remain north of 10% in the very long term, and we can expect interest rates of 1.4 - 2.1% through 2024 - i.e., my "at risk" money is betting on a long position in LETFs.
Comparing LETF Decay costs to the positive carry
But LETFs come at a cost relative to an investment in the underlying index. This cost includes hedging costs, SWAP costs, synthetic gearing costs in the embedded SAWP borrowed leg of the SWAP, option hedging costs, daily rebalancing (re-hedging) costs, continual SWAP initiation and unwind costs (arising from re-balancing and LETF in and out-flows), admin costs and a myriad of other costs not associated with a vanilla (ungeared, unleveraged) investment into the underlying index. My previous article has a close look at the logic and math behind determining these leakage "Decay" costs.
As a hypothetical example: This ~8+% positive gearing effect would favor LETFs but only where the LETF decay costs (expressed as a percentage of LETF prices) are less than 24% per year for 3X LETFs [3x8%=24%] and less than 16% per year for 2X LETFs [2x8%=16%]. We will see later that decay costs are very low (below 5%) at the moment, but can easily spike up to 40 - 60% in deteriorating market conditions.
LETF price movements can be conceptualized as amplified stock market index price movements to the exponent ^2 or ^3, diluted (or divided by) a decay factor. The LETF numerator is a function of the stock market index price movements ^2 or ^3, and the LETF denominator is driven in part by the cost of debt plus hedging costs: Roughly 90% to 95% of the hedging of LETFs is obtained through Total Return Swaps, the synthetic gearing leg of which is priced based on debt markets.
So, in summary: LETFs price movements are driven by and amplification of index prices and also by debt pricing: the turbo-charging of which results in a very volatile cocktail, and spectacular returns provided the positive gearing effect is maintained and costs are not too exorbitant.
Time in the market vs. speculation
Behavioral Finance, Market Timing and the adage "It's not about timing the market, but about time in the market."
The chart below examines entry into the market at the very worst possible times: i.e., investing immediately before the 2000 crash, immediately before the 2008 GFC crash or immediately before the March 2020 crash:
Figure 12: Entering the equity markets at the worst possible time 1 day before the crash vs Holding Cash. (Source: Y-Charts, authors notations)
My personal perspective: I do not believe that I am able to out-smart the market: I believe that the collective wisdom of the markets (as reflected in current share prices) outweighs my limited personal knowledge, that the stock prices reflect an aggregation of that collective wisdom (efficient market hypotheses: all information is available to everyone and reflected in current share prices). My personal market timing philosophy is that generally, waiting to enter the market (and remaining in low yield cash or bonds) as a strategy yields sub-optimal returns, and dilutes your "time in the market."
The above chart shows that historically at the very worst time, in the long run analysis (and setting aside the luxury of hindsight) sub-optimal entry has still resulted in healthy returns. The green arrows all indicate healthy returns even in situations where investors had entered the market at the very worst times. If you look closely at the above chart, and hypothetically conceptualize red arrows plotting the very best investment outcomes, these best case scenarios would not have had significantly higher returns (slopes) than the worst-case scenarios. Best case investing would require long periods of near zero return on cash and bond holdings, and you would need to convince yourself that your individual collective wisdom and outlook supersedes and out-smarts the collective wisdom of all other participants in the market.
In reality, we (hopefully) will not invest 100% into the market on that one day preceding the crash, so the risk of getting it completely wrong is hopefully spread and reduced (nor will we ever get the best timing precisely right). But even if you did invest everything the day before the crash, that disaster scenario has proved considerably better in multiples than sitting on bonds and cash for the next 10 years.
My general sentiment: If you want to get into the market, get in asap and try to stay 100% long (resist the temptation to sell or churn): current prices are fairly priced and reflect aggregated market wisdom which (with respect) usually far outweighs yours' or our advisor's.
Market timing for long-term investors
Comments on my previous article queried market timing of LETF investments: When is the optimal time to enter into the market? Is the market overheated at the moment? Is there a good time to get into the market? Should we "time" the market entry? Should we wait for a better time to enter the market?
These questions are particularly prevalent for LETFs because market movements are significantly amplified by all input factors. With the luxury of 20/20 vision in hindsight, March 2020 seemed the perfect time to enter the LETF market, and the 10 fold increase in the last 18 months makes LETFs now seem very expensive. But in March 2020 everybody was selling, LETF decay costs were at an all time high, volatility had increased five-fold and a large proportion of investors consequently missed the very rapid recovery post March 2020.
My personal perspective: If your strategy is positive on LETFs then buy them now. (but don't bet the farm). And any long terms hold strategy should /not be adopted by anyone not prepared or able to weather the storm and hold through a March 2020 type 67% LETF price drop, and then only for a small "at risk " portion of the portfolio.
The impact of tapering
Tapering will remove the stimulus which has (in my view) had a significantly positive impact of LETF price movements. Stimulated economies are financially, politically, expedient and make fiscal policy makers look smart. The Fed has promised to endeavor to allow financial conditions to remain "accommodative," which can be interpreted as "keeping the economy running/stimulated." At the very least, policy makers are likely to attempt to sustain the status quo for in the near future. I don't see the Fed introducing any major shocks into the system, the market has priced in tapering and inflation, and I don't see the very large over-supply of money evaporating overnight. If anything, the policy makers will apply the myriad of tools at their disposal try to keep the economy steaming ahead (but perhaps on a different tack to try to address inflation). Fears that stock prices would react negatively to the news of tapering and inflation appear to be behind us.
But please understand sideways markets do not favor LETFs: Investing the index and avoiding LETF decay is certainly the preferred strategy in flat or negative markets. We should all accept that the index will outperform an LETF in flat or negative market conditions.
Hedging your inflation risk
Following Lyn Schwartzer's views above, I see inflation as a reason to invest in stocks, rather than shy away from the markets. In my simplistic analysis, let's take Apple (AAPL) as an example: Inflation will mean that iPhones will cost more, but Apple customers should hopefully have more stimulatory monopoly money in their pockets (and they might have benefited from the economic upturn or from stock price increases), and (in my view) will continue to buy Apple products at higher prices. I don't see demand for phones declining or Apple reducing their profit margins. Considering that inflation is a reality I see a Nasdaq 100 or S&P500 investment as a safer long-term inflation hedge than holding cash or bonds. (If you live in an inflationary environment, Figure 9 illustrates that it is much safer to hold hard assets (stocks) than cash or deposits or bonds.)
So we are flying in clear air at the moment, but LETF investors should brace themselves and be prepared to weather thunderstorms ahead. LETFs are not for the faint of heart, only for a small at-risk portion of the portfolio, so make sure to mentally prepare to ride out a big dip if need be.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of TQQQ, SOXL, SPXL, QLD, SSO either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (49)
Take into consideration the secular cycle at which you are looking. This twenty-year secular Bull cycle began on April 19, 2013, and offers very different info and conclusions from the thirteen-year secular bear cycle that started on March 23, 2000. Information from diametrically opposing cycles is incompatible. It is mixing apples with elephants, comparing dissimilarities. Beware.
"3 Types Of Inflation, And How They Impact Your Portfolio"
"Investing With Inflation: 150 Years Of Data"
"QE, Wealth Concentration, And Political Risk"
The ten-year price gain of the above mentioned 3X ETF's shows profits after all the incidentals are factored into the price over the ten years. Decay, fees, and all the miscellaneous topics of worry are already included in the price.
Ten-year gains after decay, fees, etc are computed:
TQQQ +10757%
SOXL +15757%
SPXL +2648%
UPRO +2847%
TNA +657%With returns-on-investment like these, after decays, why are we concerned with decay?And for those who want to bet their money against the American economy, against the consumer, against United States employees and management teams, the Short ETF's:
SQQQ -99.97%
SPXU -99.76%
The secret is staying long and surf all the waves. The longer you stay, the better you'll be in this game.
