8 Rules For Making 200X Gains
Alzheimer's Stocks, Crushing It, Growth, Value
Seeking Alpha Analyst Since 2012
Joe Springer was the number 1 ranked stock analyst in the world by tipranks.com, and enjoys teaching about the stock market as well as crushing it.
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Summary
- Leveraged funds belong in the conversation, as does any investment that can return more than 20,000% in ten years.
- But aren't they inherently bad?
- We separate fact from fiction and establish 8 rules for making 200X.
Imagine we own $1m of the QQQ ETF. On the first day QQQ is up 10%, and we have $1.1m. The next day QQQ is down 10%. We are not back to even, we lost $110k after only gaining $100k and are down $10k. The order in which this happens does not matter -- it takes larger percentage gains to make up for the losses. This is known as the volatility tax or volatility drag.
Let’s do it again, only juice it up to 200% daily returns. On the first day QQQ is up 20%, and we have $1.2m. The next day QQQ is down 20%. We lost $240k after only gaining $200k and are down $40k. Our return increased by the leverage multiple from $100k to $200k, but the volatility drag increased by the leverage multiple squared from $10k to $40k. This is a real strike against leveraged funds -- volatility drag increases by the square of the leverage multiple. But, this is an extreme example, and if the market has returns, it does not take too much return to make up for the increased drag. For the entire history of the American market investors would have been best off sitting in a (no expenses) leveraged fund of about 2X and accepting the increased drag:
(Double-Digit Numerics)
It varies a little, but nearly every market over long time frames shows that the increased drag is well worth it:
(Double-Digit Numerics)
Did this dynamic stop working in 2010? Uh, no. While the QQQ and SPY generated lusty returns, their 2X (QLD) and 3X ETFs (TQQQ) begot truly biblical returns, fees and all:
(ycharts)
As we can see, there is another dynamic at work here -- compounding. Let’s look at the SPY example again. Let’s say we get ten 10% up days in a row. We are up 159%, great. But when we go 2X, and get ten 20% up days, we are up 619%. Our 2X turned into 4X, and the effect is growing. When we get it right the returns on leveraged funds compound quickly, and can lead to 200X absolute returns as it did with the QQQs. Wow.
So these leveraged ETFs at least belong in the conversation, if not the portfolio. But if we are going to dive in, eight guidelines are warranted:
- First, these products are obviously not for the faint of heart, just for the very risk-tolerant.
- Second, we simply must pick winners -- leveraging losers and compounding it is not a strategy for outperformance.
- Third, these products are interesting for rebalancing, but if we are going to use them in a rebalancing portfolio rather than buying and holding then we must open a seperate account and not expose the entire portfolio to the risk.
- Fourth, we must not forget about fees, which are usually about 1%, and we also pay the embedded cost of leverage which is usually 3 month LIBOR.
- Fifth, the lower the volatility the lower the volatility drag will be, so the lower the volatility the better. This goes for the volatility of the asset itself, as well as general market conditions -- these products are better in placid markets.
- Sixth, we must read the prospecti and be aware of the risks.
- Seventh, we must be aware of leverage resetting periods. Some products reset daily, so a good daily 2X fund will be up 2% when its index is up 1% on a given day. But if you look at that same fund over a three month period, it can vary significantly from 2X of its index’s performance. Other products reset on different periods. So a three month resetting 2X fund bought on its resetting day will be up 2% when its index is up 1% after a three month period. The daily moves will not track 2-1 exactly except by chance, likewise for arbitrary three month periods not begun on the resetting day. So what period is best? Well, the more often a fund resets, the greater the volatility drag will be. So daily is bad, three month funds are better. On the other hand, the more often a fund resets, the more it can compound. A 2x fund that resets at three months has a ceiling of 2X over that period, but a daily fund can return 3X or 4X or better over a three month period. So daily is great, and three month products are for the heathens. From the perspective of the investor, it’s a bit of a wash. From the perspective of the finance company, long resets give the chance for indexes to drop 33% or 50%, which is less likely in a day but more likely over three months. This has, in fact, destroyed some of these products in the past. But from the perspective of the investor, holding on to a daily fund for three months was hardly any better.
- And the eighth and final guideline is that less can be more. All of the charts will show the same rainbow we see in the Double-Digit Numerics charts above. Eventually too much volatility drag (which increases by the square of the leverage factor) overwhelms returns (which just increases by the leverage factor). The higher the leverage the higher the volatility drag will be. In the generational bull, the market was rewarding high leverage. But in the long history before that, 2X was often better than 3X, and 3X was sometimes worse than 1X. Let’s aim for 2X leverage, keeping in mind that 3X is perhaps warranted for low expected volatility, or truly exceptional expected returns.
Analyst's Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours.
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