Leveraged ETF - Gambling Insights - Episode 4 (தமிழ்) - YouTube

What? 11,800% return in 10 years?

That too from one ETF? Impossible. This must be a clickbait. But still, let's see if this is true - isn't this what you thought before opening the video?

You are right. This is clickbait. But 11,800% return in 10 years is absolutely true.

The ETF that gave that return is TQQQ. Nasdaq 100 Index's 3X leveraged ETF.

We know about ETF. But what is this Leveraged ETF?

This episode is to dig deep into that topic. For now, Leveraged ETF is in US, but not in India yet.

Ver soon, we can expect this in India as well. So regardless of whether we are gambling with this or not, it is better to know about it.

Hi. My name is Vijay Mohan. You are watching - not Investment Insights, but Gambling Insights.

What is Exchange Traded Fund (ETF)?

Holding a group of stocks in a basket (portfolio) is called ETF.

Let's take US' famous Index ETF "SPY". It is S&P 500's index ETF.

Whatever companies that are in S&P 500, will be in this ETF as well in the same weightage.

This is one on one relationship. This ETF exactly mimics the S&P 500 index.

We can buy and sell this ETF just like stocks in real time.

If this same ETF is leveraged, it is called as "Leveraged ETF".

We have already reviewed what leverage is. Increasing the return potential using less money is called as leverage.

Leveraged ETF does the same as well. This can be 2X or 3X.

That is, it can be an ETF that gives double the return of an Index or triple the return of the index.

For example, SSO is S&P 500's 2X leveraged ETF.

SPXL is S&P 500's 3X leveraged ETF.

How are they able to give 2X or 3X returns? For that, they don't have just the 500 stocks as in regular S&P 500 index.

They have derivatives like futures and swaps as well. We will review about derivatives in separate episode.

So the goal of this leveraged ETF is to try getting 2X or 3X multiple of index's returns on any given specific day.

Point to note here is, it tries. The return does not have to be exactly 2 or 3 times the index returns.

Let's take 3X leveraged ETF SPXL for example.

One a given day, their portfolio could look like - 66% stocks, 222% swaps and 12% futures.

They will have a total of 300% of S&P 500 index in their portfolio using leverage.

Their goal is to try and give a return of 3 times the actual return of S&P 500 on any given day. That is all.

That means, they buy and sell stocks, swaps and futures for the money they have in their portfolio every day.

So their focus will be only on meeting that 3X return for that given day.

They repeat the same process again next day.

Because of that daily trading, their transaction cost is high. Also they have to manage the buying and selling of swaps and futures.

So their management fees is high. SPXL's expense ratio is 1.03%.

Other than these, they have borrowing cost for swaps as well. They reduce all these costs from the end of the day price every day.

So if this leveraged ETF is trying to give a return of 3 times of the index, then even in long term, its return will be 3 times more than the actual index - right?

Nope. To understand that, let's check out a small calculation.

Let's say that our index is starting at 100 and rising 2% everyday for 10 days. By the end of the 10th day, it would have reached a value of 122.

That would be a 22% growth. What do we expect out of 3X leveraged ETF? 3 times the 22%, 66% growth.

It would have grown at 3 times 2%, 6% every day.

But it would have reached 179 by the 10th day. That would be 79% growth.

Not the 66% we expected. This is something that we should understand about leveraged ETF.

If we look at SPY's last one year return, it is 2,8%. But if we look at SPXL's return, it is not 3 times 28, 84%. But it is 103%.

But what if the index has gone down? Let's say that our index is going down 2% every day in our example.

Then the leveraged ETF would go down 6% every day. By the end of 10th day, regular index would have gone down by 18%.

We would expect the 3X leveraged ETF to go down by 55%. But it would have gone down only by 46%.

What do we learn from here? If the index goes up, 3X leveraged ETF could go more than 3 times.

But when it comes down, it comes down less than 3 times the index drawdown.

This example is to show that we should not expect exactly 3 times the return of the regular index in a leveraged ETF.

Is it possible for this leveraged ETF to go to zero?

If the index goes down by 34% from the peak, wouldn't this 3X leveraged ETF go to zero? No, it wont.

Even if the index has gone down by 34%, this 3X leveraged ETF would have gone down less than 100%.

It could have gone down more than 90%. But it would not have gone to zero.

This when the index goes down by 34% over time. But what if the index goes down by 34% on the same day?

Then this 3X leveraged ETF would definitely go to zero. But is it possible for that to happen? No.

Because S&P500 has a circuit breaker. If the market goes down more than 20% in the same day, then they will close the market down for the day.

The market will reopen only next day. What does that mean? This SPXL cannot go to zero.

Let's check out this 3X leveraged ETF SPXL's return in detail.

When SPY has given a return of 28% for the last one year, SPXL has given a return of 103%.

In last 5 years, SPY 113%. SPXL 439%. In last 10 years, SPY 277%. SPXL 2750% - 10 times more.

If we have invested $10,000 in SPY 10 years back, we would have $27,500 now.

But if we have invested the same $10,000 in 3X leveraged ETF SPXL, it would be $275,000 by now. 10 times more.

"Wow... what is there to think? We should just buy 3X leveraged ETF"

I know you would say that. Don't we all look at the point to point returns and make quick decisions? Let's take a closer look at the journey for that 10 years.

The volatility in this is making the regular index look smooth and straight. That much volatility in 3X leveraged ETF.

Specifically, take a closer look at March 2020 when the market crashed. It has fallen down from $75 to $19. 75% drop.

The fall from peak like this is called as "Drawdown". The drawdown for regular index during the same period is 33%.

But what if the index has gone down by 50%? Then this 3X leveraged ETF could have gone down by more than 90%.

How many of us can handle this kind of drawdown? We would say that it is very easy. But when it actually happens, we will not be able to stomach it. We will sell them all and get out of the stock market.

Actually the last 10 years is a great bull market.

Even in that bull market, if this has come down by 75%, imagine how this would be in a bear market. It will be painful to handle.

Now we know how leveraged ETF works and risks associated with it.

Let's how we can use this as a tool in our portfolio.

First strategy. We should know very well about leveraged ETF.

We should have that knowledge as a weapon in our arsenal.

We should not be using this during normal times. That is, we should not be buying leveraged ETF when the market is at peak.

We should wait patiently for a good opportunity.

We know on average market goes down by 20% once in 4 years. We should wait for that opportunity patiently.

If the market has gone down by 20%, then this leveraged ETF would have gone down by at least 50%.

That is when we should add this leveraged ETF to our portfolio.

When we do that, we should stick to 10 to 15% of the portfolio.

Going above that would be risky. "But isn't this already risky?" Yes. But that would be bigger risk.

Because if the market goes down by another 20%, then that would hurt our portfolio big time.

But if we are at 10% exposure, even if the market goes down by another 20%, we will have enough balance in our regular portfolio to expand our leveraged ETF exposure at that time.

For that reason, I would not recommend to go over 10% exposure.

In short, we can have half of drawdown % as leveraged ETF exposure in our portfolio.

If the index goes down by 20%, 10% exposure. Goes down by 40%, then 20% exposure. Goes down by 50%, then 25% exposure - we can rebalance like that in our portfolio.

If we do this, when the market recovers and comes up, the leveraged ETF will come up many folds.

When the index reaches its previous peak, this leveraged ETF's exposure in our portfolio will be significantly high.

At that time, we can reduce our leveraged ETF's exposure down to 10% or less.

The problem with this strategy is, we are constantly rebalancing the portfolio. That means, we might end up paying more tax.

For this reason, many use this strategy in their retirement account like IRA.

As it is tax advantaged account, we can easily rebalance it without worrying about tax.

If you would like to be bit more aggressive, then you can take the 10% exposure of leveraged ETF right now, rather than waiting for the market to go down by 20%.

If the index keeps rising, we should let that 10% grow.

Who knows. That 10% could become 50% of our portfolio.

But we know our luck. Only after we buy, the index will start going down.

If it happens that way, then we can rebalance our portfolio with a leveraged ETF exposure - half of drawdown % + 10%.

That is, if we start with 10% exposure of leveraged ETF and if the market goes down by 20%, then we can increase the exposure as half of 20, 10, +10%, a total of 20% exposure.

But if the market goes down by 40%, then we can adjust to half of 40, 20 + 10%, 30% exposure.

I am saying this % as a rough guidance. Adjust this depending on your risk profile.

Whatever it is, we should clearly define our plan. And we should follow that plan like a robot.

We should not randomly take 10% exposure and end up selling at the wrong time.

It is better to write down now saying, I will do this if the market goes down by 10%, or 20% or 50%.

When it actually happens, we should put aside our emotion and follow our defined plan.

A person called Hedgefundie has shared his strategy in bogleheads forum.

What he has basically done is, he is holding 55% of S&P500's 3X leveraged ETF UPRO and 45% of treasury bill's 3X leveraged ETF TFM in his retirement portfolio.

Every quarter, he is readjusting this allocation depending on market movement.

When he backtested this portfolio with historical data, when S&p500 has given a return of 10% on average, this portfolio has given a return of 17%.

That is an interesting strategy. I am adding the link for that in the description below. If you are interested, check it out.

Just like S&P 500 has a 3X leveraged ETF, nasdaq 100 has a 3X leveraged ETF as well. It is called TQQQ.

As I said in the intro, its return is 11,800% in 10 years.

That is, the money we have invested in this ETF 10 years ago would have grown 118 times.

$10,000 would have become $1 Million and 180,000.

If you think that it is already gambling, let's take a concentrated bet, then you can consider TQQQ.

Other than these 2, there are many other 3X leveraged ETFs.

It might work for trading, but not for long term strategy.

That is all to know about Leveraged ETF. Everyone gets worried about the market crash and recession.

But someone who knows about leveraged ETF, would wait for that golden opportunity. We will soon meet again in next episode. Thank You.