I have a "great investment idea" to share with Seeking Alpha readers today. How does a fund that has lost 85% so far in 2020 and 99% over the past five years sound to you? I must be out of my mind to consider allocating capital to this money pit, right?
The above has been the performance of the ProShares UltraPro Short QQQ (NASDAQ:SQQQ). And yet, despite the terrible track record, I believe there is a way that investors can benefit from this loser in 2021.
Source: Marc-Olivier Jodoin @ Unsplash
A word on SQQQ
The ProShares UltraPro Short QQQ is a fund that seeks to produce three times the inverse of the daily returns of the Nasdaq. In other words: if the Nasdaq is down 1% for the day, SQQQ should be up 3%. If the Nasdaq is up 2% for the day, the SQQQ should return a loss of about 6%. At each trading day, the fund's position is reset. Therefore, the daily returns compound over time.
It sounds like SQQQ is ideal for speculators looking to bet on day-to-day movements of the Nasdaq. The fact that $1.1 billion worth of shares trade hands each day on average, the equivalent of about 72% of the total AUM, seems to support the idea. But, in my view, SQQQ can also be used strategically by those with a longer-term horizon than just a day or two.
The chart below depicts a simple proof of concept. The blue line is a portfolio parked two-thirds in cash, one-third in SQQQ, rebalanced daily. The orange line is a play on the inverse daily returns of the Nasdaq index, unlevered. The fact that both lines have tracked each other almost perfectly over the past ten years suggests that SQQQ can conceivably be used to make a longer-term bearish bet against the Nasdaq.
Source: DM Martins Research, data from Yahoo Finance
Why bet against the Nasdaq?
Few will argue that betting against the Nasdaq is a smart move. Stock prices tend to rise, if given a long-enough period of time, and the tech-rich Nasdaq has climbed particularly fast since the Great Recession.
But if a triple-leveraged bearish fund like SQQQ is paired with a triple-leveraged bullish one, the end result should be something close to a market-neutral strategy designed to produce nothing but alpha (positive or negative, to be fair).
I proposed the following idea, back in mid-October:
- Start with a plain vanilla investment in the S&P 500 (SPY).
- Sell 30% of the position for cash and keep the remaining 70% intact.
- With one-third of the cash raised, buy the ProShares UltraPro S&P 500 (UPRO) to effectively return the portfolio exposure to 100% S&P 500.
- With another one-third of the cash, buy SQQQ. This should effectively add a short Nasdaq position that is worth -30% of the portfolio.
- With the last one-third of the cash, buy the Direxion Daily Small Cap Bull 3x Shares ETF (TNA). This should effectively add a long Russell 2000 position that is worth 30% of the portfolio.
- Rebalance the portfolio often, at least quarterly.
Below is the performance of the proposed portfolio since the publishing of my October article. The gap between the blue and orange lines represents pure, market-neutral alpha generated in the past two months:
Source: DM Martins Research, data from Yahoo Finance
I explained the reason behind this alpha overlay strategy that has a long small cap, short Nasdaq index bias as follows:
The recent underperformance of small cap against large cap growth seems unsustainable over the long term, especially once the economy finally rebounds. The performance of both indices relative to each other tend to revert to some sort of mean over time.
Thesis intact for 2021
Despite the underperformance of the Nasdaq relative to the Russell 2000 over the past few weeks, I continue to believe that the latter will beat the former well into the new year.
Fundamentally, the early stages of an economic recovery have consistently favored small-cap stocks, with one notable exception: the decade following the recession of 2008 and 2009, marked by the rise of Big Tech. This time, lavish monetary stimulus across the globe and the rollout of a COVID-19 vaccine should abruptly end a recessionary period and start an expansionary cycle, with little grey area in between.
From a valuation perspective, the disconnect between the Nasdaq and the Russell 2000 remains very wide. The graph below shows a long-short play on both indices, favoring small-cap stocks. Notice that we are currently still well below what one might consider "normal" valuation levels (i.e. the Russell 2000 still looks severely undervalued relative to the Nasdaq), whether normal is defined as:
- the half decade that preceded the COVID-19 crisis
- the eight-year period around the Great Recession
- the early-stage recovery years following the dot-com bubble burst
Source: DM Martins Research, chart by Portfolio Visualizer
Key takeaway
The success of the strategy outlined above relies on the Nasdaq underperforming the Russell 2000. But a different approach could be used in which the Nasdaq is pitted against other groups of stocks that an investor may think will outperform going forward: the broad market (e.g. S&P 500), value and "old economy" (e.g. the Dow Jones Industrial Average), international stocks (e.g. the FTSE 100 or the Nikkei index), etc.
The important point is that SQQQ, combined with other ETFs, can be used to express a view in a market-neutral fashion. The fact that the fund is leveraged at a ratio of three times allows it to be deployed alongside other portfolio holdings without tying up too much capital.
Investors that are comfortable trading and holding inversed and leveraged ETFs, particularly those who subscribe to the idea that the Nasdaq will likely underperform relative to other stocks in 2021, might want to take a closer look at SQQQ.
Better returns, more protection
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