Horrible Hazards: Leveraged Financial Instruments
March 01, 2024
Risk has become increasingly popular in financial markets, especially among retail investors. Beyond riskier companies and industries, riskier instruments, like leveraged funds, are another option available to investors seeking to boost returns. Leveraged funds multiply daily returns by a factor of 2x or 3x, depending on the fund. For instance, TQQQ delivers 3x daily returns on QQQ’s moves. If QQQ goes up 1% in a trading day, TQQQ rises 3%, and likewise if it drops 1%, TQQQ drops 3%. Even further, these leveraged funds are often available in both long and short varieties. SQQQ, TQQQ’s inverse, moves opposite to TQQQ daily.
Where does the allure of these types of funds come from? TQQQ, for instance, has returned over 40% on an annualized basis since inception (2010). That type of annualized return over a long period is not common and is unsurprisingly attractive to some. However, prospective investors should understand the severe risks. Since the fund is a 3x daily return fund, if QQQ took a daily hit of 34%+, TQQQ would be wiped out. Now, many would argue such a one-day loss is not plausible. However, double-digit one-day losses in the major indices are not unheard of. On Black Monday, October 19, 1987, the Dow Jones Industrial Average saw a 22.61% decline.
Further, leveraged instrument wipeouts have occurred. In the spring of 2020, various factors culminated in crashing oil prices, and investors in 3x Exchange Traded Notes (ETNs) long on oil saw wipeouts and delistings. The Journal spoke with one investor in his mid-twenties who saw his investment in one of these leveraged oil funds, OILU, evaporate. He did not want to use his real name out of embarrassment but said of the experience, “I learned that with greater risk comes greater reward… and greater heartbreak.” Moving forward he sees the value in steering clear of elevated risk in favor of “... play[ing] it slow and steady.”
Even if a total wipeout does not occur, the volatility and fluctuations a fund like TQQQ has endured are certainly of concern. From November 2021 to October 2022, TQQQ took around an 80% hit and has still not recovered to its November 2021 levels (in fact, it is around 30% lower than those levels) despite the underlying QQQ hovering around an all-time high.
There is no shortage of leveraged funds for investors to choose from; in fact, the Bank of Montreal recently launched XXXX, a 4x leveraged S&P 500 ETN. Their availability does not mean they should be purchased. These instruments, while seemingly great during good times, have the potential for devastation during rough patches. An important question must be asked as to the line when purchases of these instruments cease to be investing and become gambling. As regulators consider further leveraged instruments, the substantial risks posed to investors should not be forgotten.