TQQQ and Volatility Decay

TQQQ and Volatility Decay—Surprise! TQQQ can do very well when simply bought and held over long time frames. But my 9Sig plan does even better with it by harnessing the high volatility.

Record your investing question at 310-734-8889.

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Note: The following is not a word-for-word transcript. For that, please see the episode on YouTube.

Today’s question is one I receive on a regular basis, and was asked in various forms by several people in the past week.

Representing the group is Nathanael from Chicago, who asks about volatility decay in ProShares UltraPro QQQ (TQQQ), a triple-leveraged, i.e. 3x, fund that tracks the Nasdaq 100 stock index:

Discussion with a friend who joined the Sig System, about TQQQ. He’s been reading articles that arise in times like these that decry the foolishness of investing in funds like TQQQ, which warn about volatility decay.

3. What is volatility decay, and why is it not a concern for our plans? The article in question emphasizes this as a primary problem with holding TQQQ on a long-term basis.

This is a canard that won’t go away!

It’s become an evergreen attention-getter, with new articles warning about it every year.

I’m going to answer your three questions, Nathanael, but out of order to make a more coherent presentation for listeners who may not be as familiar with TQQQ and this issue more broadly.

I’ll go through the definition of volatility decay,

show that it’s not unique to leveraged funds,

reveal an easy way to see that it doesn’t preclude holding them even over fairly long time frames,

and explain how my plans go beyond holding TQQQ to taking advantage of its wide price swings.

Volatility decay, sometimes called performance decay, refers to the problem of leverage amplifying the moves in an index such that declines in a choppy pattern can grind it down to less than the performance of the index it’s tracking.

The math behind this is simple, and covered in my books. Consider, for instance, an index starting at 1000 then going through the following daily moves:

+1%
-1%
+0.5%
+1%
-2%

At the end of this five-day journey, it’s at 995 (rounded).

Now let’s run it through 3x leverage, assuming perfect tracking, so:

+3%
-3%
+1.5%
+3%
-6%

At the end of this five-day journey, the 3x tracking is at 982.

1x ended at 995
3x ended at 982

There’s your volatility decay. Mathematically it exists, and most articles warning against the dangers of holding TQQQ and other leveraged funds highlight the math to argue their point.

And, I should add, most do so as if they’re discovering it. They’re not.

This issue was been known since the first day a person borrowed money to buy something, which was, what, hundreds of years ago? It was certainly well understood by the time leveraged ETFs launched. And of course I knew about it and factored it into my research when devising my leveraged Signal plans.

But notice that it’s not unique to leverage.

Leverage merely magnifies, well, everything. The up and the down, and therefore the distances in between. In my earlier example, it would take the index only a 0.5% jump to regain break-even at 1000, but would take the 3x leveraged fund a 1.8% jump to get there.

So … good thing it has 3x leverage on its side, right?

It declines more deeply, but recovers more steeply.

In this example, when the index recovered 0.5% the 3x fund would recover 1.5%, putting it not so far from break-even: 997, requiring just another 0.3% flutter away from break-even at 1000.

Another angle on this that non-leverage also needs to recover more than it lost. This matters because critics of leverage say that it declines so far that it takes forever for it to recover, but the issue of performance decay in this regard is not unique to leverage.

In our earlier example, any decline in the index requires a bigger gain to regain break-even. If the index declines 10% from 1000, it must then appreciate 11.1% to regain break-even. Bigger examples make this more clear. A 50% decline requires a 100% recovery to regain break-even.

Note that even mortgages introduce “volatility decay.”

If you put down $200k on a $1m home, then the home declines 30%, on paper you’ve lost all your equity and then some. Because of leverage, you lost more than you invested, to the tune of a 150% loss rather than a 100%.

Note that this cannot happen in a leveraged ETF. Your loss is limited to the full amount of your investment, making leveraged funds one of the safer ways to put leverage to work.

Back to your unfortunate real-estate investment.

You now owe $1m on a $700k home, so even if you sell it you won’t recoup your down payment and will still owe the bank $100k. That’s called being underwater.

To regain break-even on this home, you would need it to rise not 30% but 43%. There’s your volatility decay in the housing market.

Pause here to ask yourself: If holding a leveraged investment over the long term is so dangerous, then why does real-estate financed with 30-year mortgages work? Because the housing market rises over time, but guess what? So does the stock market.

Which leads to my next point: Even buying and holding TQQQ has worked over long time frames.

{ Transition Music }

You don’t even need mathematical explanations to see this. Just pull up a long-term chart of TQQQ. I’ll do so now…

From the end of 2010 to the end of 2020, TQQQ rose nearly 6,000%.

What more proof do you need that leverage can work over long time frames?

Whenever I point to a time frame like this one, a critic says, “Well, you cherry-picked a good one. But on the forever time line they don’t work.”

But we’re not examining forever, which is a tough time frame to encapsulate. We’re looking at whether leveraged funds can work when held over long time frames. The answer is clearly: yes.

A decade’s not forever, but it counts as “long” in most people’s book, and 2010 to 2020 was a decade that included all the usual volatility and many TQQQ crashes along the way, such as:

-44% in the debt ceiling brinkmanship of 2011
(but then rising 130% in the next 7.5 months)

-41% from July 2015 to February 2016
(but then rising 73% in the next 7.5 months)

-27% from January to April 2018
(but then rising 63% in the next 5 months)

-55% in the autumn tech-wreck of 2018
(but then rising 129% in the next 11 months)

-69% in the February to March 2020 covid crash
(but then rising 344% in the next 5 months)

And so on. This decade was not cherry-picked for its smooth upward line. There are no smooth upward lines. There’s a generally rising line, which everybody conveniently forgets in downswings, but it’s there.

Stocks fluctuate along that generally rising line, and leveraged funds magnify those fluctuations. Yes, they enter bigger setbacks than the indexes they track, but they then recover at faster speeds to, ultimately, higher highs.

Even over this volatile decade noisy with warnings from bears on everything from federal debt threatening the dollar’s reserve currency status, to the debt ceiling, to the taper tantrum, to the election of Donald Trump, to Brexit, to valuation concerns, and just the usual mental detritus of headline obsessers.

For example, the news in March 2020 was grim for stock investors.

MarketWatch ran an opinion piece warning about a “watershed” moment for stocks if they couldn’t home some pet level of the author’s.

Joseph Calhoun at Alhambra Investments titled a report, “Is this the Beginning of a Recession?” He opened with:

“As I sit here Monday evening with the Dow having closed down 2000 points and the 10-year Treasury yield around 0.5%, the title of this update seems utterly ridiculous. With the new coronavirus still spreading and a collapse in oil prices threatening the entire shale oil industry, recession is now the expected outcome. Most observers seem to question only the potential length and depth of the coming downturn. … if we get sufficient evidence to call a recession, we will do more selling.”

Nice. Talk of selling, and plans to sell, as prices careen downward.

My plans do the opposite: perk up and buy into low prices, then perk up and sell into high ones.

Finally, none other than the New York Times ran a report, “Dow Skids Into Bear Market, Heralding an Uncertain Future,” which opened thusly:

“The 11-year bull market, which grew in tandem with one of the longest economic expansions in United States history, weathered a European debt crisis and survived President Trump’s trade war with China, is dead… Falling share prices have incinerated $5 trillion in stock market wealth in less than a month.”

Five months later, TQQQ had risen more than 300%.

{ Transition Music }

Finally, although leveraged ETFs can work when held over long time frames, despite warnings of volatility decay, they work best with a plan that puts their heightened volatility to work. That’s what my Sig plans do.

The 9Sig plan buys the lower lows of TQQQ, and sells the higher highs, on a quarterly basis.

This same process works on non-leveraged funds or lesser-leveraged funds, and indeed I offer one of each of those, 3Sig and 6Sig, respectively, but it works even better with the 3x leverage of TQQQ and the high volatility of the Nasdaq 100 index.

It’s not for anybody unwilling to go through big swings, but for those who are, and confident in the generally rising line, the 9Sig approach is a winner.

Nathanael, you asked if the fact that the 9Sig plan never allocates less than 60% of its account to TQQQ makes the plan a buy-and-hold approach.

First, the plan can allocate less than 60% of its balance to TQQQ. If the fund rises enough, the plan will signal selling more and more, without a mechanism to prevent it from selling to less than a 60% allocation.

I know why you flagged 60%, because that’s what we reset back to from time to time, such as after a 30 down period in which we skip two quarterly sell signals to stay invested for a recovery, like we’re in now. However, there’s no rule saying the plan can’t allocate less than 60% to TQQQ.

Second, no, it’s not a buy-and-hold plan. It’s a quarterly price reaction plan that tends to keep most of its balance in the stock fund. All long-term plans must do so or they’ll lose to the S&P 500 because … stocks generally go up. Remember that long-term, rising line.

Our buys and sells of TQQQ are not perfectly timed, but nothing is. They take the correct action each quarter in light of that quarter’s price change. That’s all, but that’s enough.

When TQQQ goes up a little, we sell a little. When it goes up a lot, we sell a lot. When it goes down a little, we buy a little. When it goes down a lot, we buy a lot.

We can, and have, run out of buying power, and in such time frames the plan is indistinguishable from a buy-and-hold plan, but it eventually exits that posture and starts reacting to quarterly price changes again. Its time frames that look like buy-and-hold are begun at prices well below the fund’s last cycle price peak because of the quarterly signal purchases that precede an all-in allocation.

It’s not a perfect approach, but it’s one that beats the market over time, and it’s a superb way to harness the wide fluctuation of TQQQ.

On a closing note, don’t get scared by fancy sounding language around leveraged ETFs. There’s nothing complicated going on. They simply amplify the daily moves of an index, which works in most time frames even on a buy-and-hold basis, but works splendidly in a plan that buys their extra low prices and sells their extra high ones.

I read in one report warning against volatility decay, the following: “[Leveraged vehicles] are designed for short term directional bets as the returns are path-dependent. They should not be held long term.”

This is good for a few laughs.

First, what investment returns are not path-dependent? Whatever you own, it will produce profit or loss depending on the path of something. This is not unique to leveraged funds.

Second, short-term bets are a waste of time. Nothing works to reliably call the market in the short term, not sentiment, moving averages, valuation, nothing. Seriously, nothing. So if leveraged funds are only good for a useless activity, then they’re useless, but our experience proves they’re not.

Third, it’s easy to see on a chart that leveraged ETFs can do fine over a long term, such as the decade I examined earlier in this episode.

It’s easy for analysts and marketers to create fear around the wild swings of leveraged ETFs, but if you understand them, know what you’re signing up for, and use those swings properly, you can profit handsomely.

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