Leveraged ETFs, Dilapidation And $-Cost Averaging

The lower of these two charts is an ETF which tracks the Nasdaq 100 index. In the higher chart, the ETF does something similar but is five times leveraged and rebalanced daily.

There is a striking difference between the two charts. Like the Nasdaq 100, QQQ has been hitting new peaks for almost a year and a half. QQQ5 has recovered strongly from the 2022 lows but is still a long way below the peak.

The reason why is the effect of daily rebalancing.

Leveraged ETFs (Exchange-Traded Funds) experience a phenomenon often referred to as decay or value erosion over time, which is mainly due to daily rebalancing. Here’s why:

1. Daily Rebalancing and Compounding: Leveraged ETFs aim to deliver a multiple (e.g., 2x or 3x) of the daily performance of an underlying index. This daily resetting means that the fund’s structure gets recalibrated each day, and over time, this compounding effect can cause the performance to deviate from what a simple multiplication of the index’s return would suggest. In volatile markets, this deviation can become significant, leading to decay.
2. Volatility Drag: Leveraged ETFs are more sensitive to market volatility. When the market moves up and down, the daily resets mean that losses tend to compound faster than gains, especially in choppy markets. Even if the underlying index returns to its original price, the ETF may not.
3. Fees and Transaction Costs: Leveraged ETFs often have higher expense ratios than regular ETFs due to the complex financial instruments (like derivatives) they use to achieve leverage. These higher costs can eat away at returns over time.
4. Mathematical Erosion: The daily rebalancing makes it difficult for these ETFs to maintain their intended leverage over extended periods. For example, if an index goes up by 5pc one day and down by 5% the next, the leveraged ETF may lose more than the index itself due to how the gains and losses compound.

For short-term trades, leveraged ETFs can be useful, but they’re not ideal for long-term holding because of the erosion caused by volatility and rebalancing, leading to “decay.”

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A Licence To Print Money

This decay dilapidation is a problem, especially for QQQ5 but it doesn’t make the ETF a bad investment as long as you turn the volatility to your advantage. For ease of calculation, I have imagined investing an equal amount, $1,000, every six months. QQQ5 has been trading for seven half-yearly intervals, meaning $7,000 has been invested. But this money has bought 11,230 shares worth $18,866 at the latest price.

QQQ5 may be trading far below its peak but investing equal amounts every six months has been extremely profitable.

We can do a similar analysis for QQQ3. The results are staggering. Investing an equal amount every six months since the ETF was launched in the second half of 2012 would have turned $25,000 into $326,667. Who cares about dilapidation?

What lesson can we draw? Regularly investing in a volatile investment instrument with strong upward momentum is a highly profitable exercise. If QQQ5 ever reaches a new all-time peak, it will be fantastically profitable, but it won’t matter if it never does. The key to the success of the investment is volatility.

Share Recommendations (25 October 2024)

Invesco QQQ Trust Series QQQ

Wisdomtree Nasdaq 100 3x daily leveraged QQQ3.

Leverage shares 5x long Tech 100. QQQ5

Strategy – $-Cost Averaging And Leveraged ETFs

I have done the calculations using six monthly intervals because I am lazy and also because I doubt it makes a huge amount of difference. You could do it for three months, one month, a week, a day, or an hour. It depends on how deep your pockets are.

You also need to bear in mind that downward volatility can be scary. In 2022 both these ETFs plummeted which would have created terrifying paper losses. You need faith that however low they go they will always recover sharply.

If you want an exciting but less scary ride you could $-cost average with QQQ or do all of them like a three-horse race.

There is no such thing as a guaranteed sure thing in investment but $-cost averaging with any or all of these three shares if sustained for long enough comes close.