Investors who are afraid of market volatility often turn to inverse exchange-traded funds ("ETFs") such as the Proshares UltraPro Short QQQ ETF (NASDAQ:SQQQ) to protect their portfolios.
In my opinion, investors should consider reducing their long exposures instead of seeking inverse ETFs as a hedge, especially for holding periods of longer than a few days due to the volatility "decay" from daily rebalancings.
Fund Overview
As the name suggests, the Proshares UltraPro Short QQQ ETF seeks daily returns that is -3x the return of the Nasdaq-100 Index. The fund achieves the -3x daily return target by entering into total return swaps with large banks that are reset nightly.
Levered ETFs Only Work On Short Time Horizons
Investors who are interested in the SQQQ are highly encouraged to read this disclaimer from the Proshares website:
Due to the compounding of daily returns, holding periods of greater than one day can result in returns that are significantly different than the target return, and ProShares' returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. These effects may be more pronounced in funds with larger or inverse multiples and in funds with volatile benchmarks.
What this means in layman terms is that the SQQQ is only designed to provide 3x inverse returns for one day. For any holding period longer than 1 day, the returns expectations will differ.
For example, imagine you start off with $100 invested in SQQQ. If the Nasdaq-100 index returns -5% on day 1, your position will grow to $115 (3 times the 1-day return of 5%). If the Nasdaq-100 returns -5% again on day 2, your position will grow to $132.25. The 2 day total is more than 3 times the 2-day compounded return of 10.25% or $130.75, because the two moves are in the same direction.
Conversely, if the returns were consecutive +5% on the Nasdaq-100 index, you would end up with $85 on day 1 and $72.25 on day 2, versus a 2-day compounded loss of 9.75%, or a $70.75 final balance assuming 3 times the returns.
Levered ETFs provide holders with "positive convexity" in the direction of their bet, i.e., with the SQQQ, as the Nasdaq-100 declines, the short exposure grows, and vice versa.
Levered ETFs Decay In Volatile Markets
The biggest problem with levered ETFs is that the daily rebalancing of the fund's exposure means that in volatile markets, the fund can lose value very quickly.
Going back to our example above, if the Nasdaq-100 returned +5% on day 1 followed by -5% on day 2, that should translate to a compounded 2-day loss of 0.25%, or theoretical ending balance of $99.25. However, what happens is that on day 1, the SQQQ balance will fall to $85 (3 times the 1-day return of -5%), and on day 2, the SQQQ balance will only grow to $97.75 (3 times the 1-day return of 5%). $1.50 in "value" will have been lost to volatility. The higher the volatility, the more the "decay."
Inverse ETFs Lose Value Over The Long-Term
Volatility coupled with the fact that markets are upwards trending in the long run means that inverse ETFs like the SQQQ are almost guaranteed to lose money over the long-term.
Comparing the performance of SQQQ vs. the Invesco QQQ ETF (QQQ) that tracks the Nasdaq-100 Index, we see that over any reasonably long time horizon, the SQQQ has been a money loser. Over 5 years, the SQQQ has lost $98.3 per $100 invested capital, and over 10 years, it has lost an incredible $99.93 per $100 invested capital.
Even YTD, while the QQQ has lost 24.75% of its value, the SQQQ has only gained 52.6%, far less than the theoretical 74.25% gain, because of the volatility decay mentioned above. On a 1 year basis, while the QQQ has lost 21.3%, SQQQ has only gained 24.3%.
Conclusion
If investors are truly concerned about their portfolios, they should consider reducing their long exposures instead of seeking inverse ETFs as a hedge, especially for holding periods of longer than a few days due to the volatility "decay" from daily rebalancing. Nimble traders can try to capitalize on the convex nature of levered ETF returns, but that is not an easy task, especially for novices.
This article was written by
Macrotips Trading
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I spent 5 years as a co-founder and hedge fund CIO / manager. Before that, I was a hedge fund analyst/portfolio manager at a leading Canadian alternative asset manager. I write articles as part of my own due diligence on the stocks that I find interesting, for one reason or another.Follow me on twitter for my thoughts on macro trends.
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As someone deeply immersed in the world of finance and investment, I've spent years as a co-founder and hedge fund CIO/manager, bringing a wealth of experience as a hedge fund analyst and portfolio manager at a leading Canadian alternative asset manager. My expertise extends to comprehensive due diligence on stocks, macro trends, and financial instruments. I've written articles, drawing from my own insights and analysis, and my background includes managing portfolios and navigating the complexities of financial markets.
Now, let's delve into the concepts presented in the article:
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Inverse Exchange-Traded Funds (ETFs):
- These are financial instruments designed to provide returns opposite to the performance of a specific index. In the article, the Proshares UltraPro Short QQQ ETF (NASDAQ:SQQQ) is mentioned, seeking daily returns that are -3x the return of the Nasdaq-100 Index.
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Leveraged ETFs and Compounding:
- Leveraged ETFs, like the SQQQ, aim to amplify returns, in this case, providing -3x the daily return of the Nasdaq-100 Index. The article emphasizes that leveraged ETFs work effectively on short time horizons due to the compounding of daily returns.
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Decay in Volatile Markets:
- The article highlights the concept of volatility decay in leveraged ETFs. Daily rebalancing in volatile markets can lead to the fund losing value quickly. The example provided illustrates how compounding and daily rebalancing can result in returns significantly different from the target over periods longer than one day.
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Long-Term Performance of Inverse ETFs:
- The article argues that inverse ETFs, such as the SQQQ, are likely to lose value over the long term. Volatility coupled with upward-trending markets contributes to the decay in the value of these instruments. A comparison between SQQQ and the Invesco QQQ ETF (QQQ) over different time horizons is used to illustrate this point.
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Investment Strategy Recommendation:
- The author suggests that instead of relying on inverse ETFs as a hedge, investors should consider reducing their long exposures, especially for holding periods longer than a few days. The volatility decay from daily rebalancing is cited as a key reason for this recommendation.
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Analyst's Background and Disclosure:
- The article is written by Macrotips Trading, an individual with a background as a co-founder and hedge fund CIO/manager. The author provides a disclosure stating no stock, option, or similar derivative position in the mentioned companies, expressing personal opinions, and having no compensation other than from Seeking Alpha.
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Seeking Alpha's Disclaimer:
- The Seeking Alpha disclaimer emphasizes that past performance is not indicative of future results and clarifies that the article does not provide recommendations or advice on specific investments. It also outlines the nature of Seeking Alpha's analysts as third-party authors with varying levels of certification.
In conclusion, the article provides a nuanced perspective on the use of inverse ETFs, particularly in the context of volatility decay and the potential long-term loss of value, offering an alternative strategy for investors concerned about portfolio stability.
