SH - How To Hedge Your Big Tech Gains With PSQ

2023-11-22 00:03:00 ET

Summary

• Buying the ProShares Short QQQ ETF provides a unique hedge against Big Tech stock losses, while offering a strong dividend yield.
• The product is a lower-risk way to profit from any decline in the NASDAQ 100 index.
• The daily rebalancing feature of this ETF limits net losses, while compounding gains to the upside, when interest rates are high like today.

I have been writing story after story since early summer on the growing risk owning 2023's Big Tech winners. The combination of an oversized jump in long-term interest rates since June on top of the sharply increasing odds of recession into the beginning of 2024 are my bearish logic in a nutshell.

One complaint I get is readers don't want to take the capital gains tax hit selling shares owned for years or even decades. While I fully appreciate this excuse, there are other ways to "lock-in" your hefty profits without liquidating shares directly. One way is to sell covered call options on your position, another is to actually buy put options that benefit when stock prices fall.

A third, and perhaps even better way to hedge today is by purchasing the ProShares Short QQQ ETF ( PSQ ). Why do I say that? It's a function of futures/swap premiums on the NASDAQ 100 index and high interest rates on cash investments opening a unique opportunity to own PSQ over the next 6-12 months (assuming these advantageous variables remain in a similar setup to late 2023). Really, it's the most productive time I can remember to hold this inverse ETF looking at its trading design and high yield component since 2007, especially if a monster stock market bear phase is next.

In essence, you can hedge $10 in Big Tech longs (as a group) with $10 of PSQ owned, AND collect 4%+ in annual cash dividends on PSQ (plus whatever you receive from your regular long position), without too much time decay on the underlying short product ruining this simple trade offset. You don't have to borrow shares in a classic short sale position, paying interest expense, and being susceptible to a call by your broker at the worst possible moment.

I wrote an article on the PSQ cousin ProShares Short S&P 500 ETF ( SH ) in early September here. It's basically the same argument for holding PSQ. To boot, I will say my SH hedge has worked as planned, providing far less loss than you would expect on the minor rise in the S&P 500, while paying a quarterly dividend of nearly 1.2% in September.

PSQ Holdings

You will notice on the list of total cash and swap holdings from November 17th, 2023, PSQ mostly holds cash reserves (Treasury Bills). Its net 100% short position is a function of swap contract agreements with Wall Street's biggest money-center banks.

The Top 10 weightings for the NASDAQ 100 index on September 29th, 2023 are listed below. The index design is completely skewed toward a handful of the most valuable Big Tech names, with 47% of the entire index value sitting in 101 positions, including 2 classes of shares for Alphabet/Google ( GOOG ) ( GOOGL ). The index is usually capitalization weighted, but went through a technical rebalancing adjustment in July to slightly lower the concentration of Alphabet, Apple ( AAPL ), Microsoft ( MSFT ), Amazon ( AMZN ), and NVIDIA ( NVDA ).

So, the point to explain for new PSQ readers and potential investors is the cash holdings earn interest. When short-term rates on cash are low, like 2020-2022, the 1% annual management fee eats away at the ETF's value. However, when rates are high like November 2023, expenses are covered and what remains is paid to trust holders as a dividend. Today the trailing 12-month dividends paid by ProShares Short QQQ amounted to a 4.3% yield on a low-$10 trust quote.

The beauty of this design is total returns including dividends in a FLAT stock market scenario over the next year could easily be HIGHER than owning the ProShares NASDAQ 100 ETF ( QQQ ) stocks outright, paying a measly dividend distribution well under 1% as a group!

Historical Performance Comparisons

Now let's review how ProShares Short QQQ has performed over various time periods in the real world. At first glance, the 18-month chart below highlights an investment in clear downtrend for price. You have to remember Big Tech has been the leading sector to own in 2023, especially the nicknamed Magnificent 7 , which is essentially the top holdings of QQQ long, shorted through ownership of PSQ.

The good news for PSQ holders is the current structure of swap premiums to market pricing, high interest income on cash holdings, and the way its daily rebalance slows net ETF price declines vs. gains in the underlying index (all other variables remaining unchanged), the +36.5% total return from QQQ has only translated into a -23.6% PSQ loss over the past 12 months. And, PSQ has equally "outperformed" a 1-for-1 hedge loss in price/total returns on time periods under a year, for the same reasons.

12-Month Comparison

6-Month Comparison

3-Month Comparison

1-Month Comparison

In addition, the extra cash interest income of late plus the way the other pricing variables have worked, in combination, allowed a 3-year total return performance near a correlation of -1.0. The +34.5% QQQ gain over 36 months has translated into a -32% PSQ loss for buy-and-hold positioning (with the help of a -35% NASDAQ 100 selloff in 2022).

3-Year Comparison

On a cautionary note, had you held PSQ over the last decade, during arguably one of the strongest periods for Big Tech in Wall Street history, returning +409% for advancing wealth, PSQ fell -86% for a total return. Effectively, shorting a huge bull market over many years is a horrible stand-alone idea.

10-Year Comparison

Closest Historical Peer

I will say, high and rising interest rates over several years, overenthusiasm for the U.S. stock market, a wickedly inverted Treasury yield curve, and the likelihood of recession appears quite/most similar to the 2007 economic setup on Wall Street (just before the Great Recession and banking crisis of 2008-09).

One striking similarity to 2007 is the pattern of dividend payout increases by ProShares Short QQQ. Below is a chart of 2023's sharp jump in extra income earned by the trust and paid to owners. Compared to QQQ's net trailing cash distribution rate of 0.55% (after expenses), getting 4.3% has been very advantageous.

During 2007 the trailing PSQ cash yield rose from 1.5% to a little over 6% in November, which marked the high point for yield. It also marked the peak NASDAQ 100 price for the year. The flip side is PSQ inversely reached its low quote at the same time.

November 2007 to March 2009 Comparison

Then, from November 2007 to November 2008, PSQ outlined perhaps its best intermediate-term gain ever. The high initial yield and positive effects of daily rebalancing helped to mathematically "compound" buy-and-hold gains for PSQ, on regular QQQ losses in price during 2008. At its zenith in November 2008, PSQ's total return gain was +85% vs. the equivalent -55% loss in QQQ.

November 2021 to December 2022 Comparison

The next smartest period to own PSQ in recent memory was during 2022. Again, Big Tech names peaked during the month of November in 2021. Absent any significant cash yield component, PSQ rose +37.4% in price into December 2022, as opposed to the -33.5% drop in QQQ wealth.

Final Thoughts

To me, ProShares Short QQQ is kind of two investments in one. I get a strong cash-yield while I wait, on top of a position that will benefit from another bear phase on Wall Street. I rate PSQ a Buy and own a stake to hedge my longs today.

If you have major position sizing, a reasonable and measured strategy to capturing your Big Tech gains might be a multipronged approach. You could sell one-third of your stake in Big Tech names, to keep tax bills to a minimum and raise cash. You could sell covered calls on another third to put income in your pocket (possibly used to offset some tax liabilities and fund other trades). And, you could purchase ProShares Short QQQ as a 1:1 hedge on the remaining position. In this fashion, you can limit potential losses in the event a whopper bear market for Big Tech is coming during 2024.

In addition, aggressive traders wanting to short the NASDAQ 100 picks directly can use PSQ, while limiting downside risk (to less than 1:1) on continued price advances in the technology sector. The daily rebalance feature really works in your favor today as the result of high cash interest income offsetting trust expenses and swap premiums. This combination of ETF traits has kept downside percentage losses lower than usual, while also compounding (turbocharging) your gains when the stock market overall dives.

In all honesty, it's not the normal setup for this ETF product. My research suggests a better than 1:1 beneficial PSQ hedge against material QQQ and Big Tech losses remains available to investors into early 2024.

Thanks for reading. Please consider this article a first step in your due diligence process. Consulting with a registered and experienced investment advisor is recommended before making any trade.

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