2023-08-21 09:31:08 ET
Summary
- This article is looking at the possibility of coupling together short positions in both TQQQ and SQQQ in a pairs trade.
- Leveraged ETFs experience NAV erosion and are not advisable as long-term investments.
- This TQQQ SQQQ pairs trade has a recent annual decay rate of 21.175% and expected returns of around 18%.
- Because this strategy requires shorting both tickers, I currently rate TQQQ and SQQQ as Sells.
Thesis
I began researching low-volatility pairings a couple months ago and plan on designing a margin portfolio once I have found enough high-quality targets. While researching low-volatility couples, I noticed some of the short positions I was using as volatility hedges were producing attractive returns of their own. In addition to researching combining covered call ETFs with short positions in leveraged ETFs, I am also exploring the potential of shorting two inversely correlated leveraged ETFs. I recently wrote an article covering a SOXL vs. SOXS pair , and plan on covering some of the more attractive leveraged pairings that I come across.
This article is looking at the possibility of coupling together short positions in both ProShares' UltraPro QQQ ETF ( TQQQ ) and their UltraPro Short QQQ ETF ( SQQQ ). Because this strategy requires the shorting of both tickers, I currently rate TQQQ and SQQQ as Sells.
Background of Funds
Both funds seek to achieve behavior which corresponds to 300% or -300% of the daily performance of the NASDAQ-100 Index. Both funds carry a gross expense ratio of 0.98%.
Why They Erode
Leveraged assets decay because they have a higher beta than the underlying their behavior is tied to. Because they are designed to move according to the daily price action of their underlying, they are unable to maintain correlation over longer periods.
When an asset goes down by 20% in one day, it would need to gain 25% on the following day to return to its previous value. This problem is enhanced during more violent moves. A 33% drop would need a 50% gain to return to its previous value, while a 50% drop would then require a 100% gain.
To illustrate the potential for value erosion in leveraged ETFs, let's use an example whereby the QQQ goes down by 10% one day, and then up by 11.1111% the next. With these returns, QQQ will return to it's original value.
100 x (0.90) x (1.111111) = ~100.00
However, the 3-times leveraged ETF, in response to these underlying QQQ moves, would land at a much different point:
100 x (0.7) x (1.333333) = 93.33331
So to recap this scenario, the underlying ETF would have flat performance, while the leveraged ETF would have lost ~6.66%.
Although the above example would represent an unusually large two-day drop and then recovery, the losses from the smaller moves that regularly occur compound over time. This is why it is not advisable to be long a leveraged ETF over longer timeframes. Enough people have misunderstood this that the SEC and FINRA were both forced to issue warnings.
Historical NAV Erosion
First lets take a look at how this has played out over time, and then I will cover the implications of this. For the last month TQQQ is down by 19.14% while SQQQ is up by 21.66%; combined the couple is up by 2.52%, or an average of 1.26% each. The short couple strategy would have suffered a loss of ~1.26% on total capital.
TQQQ vs. SQQQ 1-Month (Seeking Alpha)
Over the last year TQQQ is down by 1.93%, while SQQQ is down by 40.42%. Their average rate of decay is 21.175%, leading to a return of ~21.18% for the combined Short strategy.
TQQQ vs. SQQQ 1-Year (Seeking Alpha)
Over the last 3 years TQQQ is up by 7.37%, and SQQQ is down by 83.72%. Their average rate of decay of decay is 38.175%, leading to nice profits for the Short strategy.
TQQQ vs SQQQ 3-Year (Seeking Alpha)
Over the last 5 years TQQQ is up by 124.8%, and SQQQ is down by 98.32%. The couple had gains of 13.24% (average), so the Short strategy would have losses of that same amount.
TQQQ vs. SQQQ 5-Year (Seeking Alpha)
Notably, over the last 10 years TQQQ is up by 2020.65%, and SQQQ is down by 99.94%. The average return is +960.4%, which would have led to very significant losses for the Short strategy.
TQQQ vs. SQQQ 10-Year (Seeking Alpha)
After looking over those, you have probably noticed a problem. Over longer timeframes the SQQQ's losses approach 100%. However, over those same periods the TQQQ has the potential to go up by far more than 100%. Thankfully, we can mitigate this somewhat through frequent rebalancing and we also have the option of intentionally imbalancing their weightings. Even through regular rebalancing, the strategy is unlikely to do well during all market conditions. When markets trend strongly, the strategy of Shorting both leveraged ETFs will likely experience losses. Conversely when markets are in a choppy range, the strategy should perform well.
Weightings
My minimum variance calculator is telling me that taking on a $1,011.12 short position in SQQQ for every $1000 that one is short TQQQ, produces a minimum variance of 0.0141. As both funds are designed to move inversely to each other, I was expecting the minimum variance weighting to be very close to 50/50.
TQQQ (short) vs SQQQ (short) Weightings (By Author)
Instead of choosing to target minimum variance, one could chose to lean into the fact that SQQQ loses value more consistently than TQQQ and take a lopsided position. Depending on what ones volatility tolerance is, this SQQQ-heavy lopsided position could be anywhere between 50/50 and 0/100. In addition to 50/50, I will estimate returns for a 2 to 1 (33.33/66.66), a 4 to 1 (20/80), and a pure SQQQ short position.
Distributions
Both ETFs come with non-regular distributions. Over this last year, TQQQ has paid a 0.99%, and SQQQ paid a 3.09%. Because this strategy has us shorting both ETFs, we will end up paying the distributions, so they are expected to produce a small drag on returns.
These yields are only produced situationally. When looking at their distributions, they appear to be staggered. Even though they are irregular, when I estimate returns later, I will assume the yield will remain unchanged.
TQQQ Distribution History (Seeking Alpha)
SQQQ Distribution History (Seeking Alpha)
Fees
Because this strategy has us shorting both funds, we must consider their annual cost to borrow fees. These values vary over time. Using values from Fintel, and only looking at the 'Latest' column, the last ten days of borrow fees TQQQ comes to an average annual rate of 0.953%.
TQQQ Borrow Fees (Fintel.io)
The last ten days of borrow fees for SQQQ comes to an average annual rate of 0.868%.
SQQQ Borrow Fees (Fintel.io)
Expected Returns
I'm going to calculate expected returns using a variety of weightings. First, if they are weighted at 50/50, we can look at their combined annual decay rate from earlier. The effects of their 0.98% annual gross expense ratio in both funds is already reflected in the 21.175% annual decay of the couple. The two positions have a recent combined annual distribution of 2.04%, and an average annual cost to borrow of 0.91%. Removing these from the recent annual decay rate gives us a rough estimate for total returns of 18.2%.
Looking at them independently now: the TQQQ went down by 1.93% over the last year, it also paid a 0.99% yield, and had a recent cost to borrow of 0.953%; shorting it would have netted roughly a -0.013% return. The SQQQ went down by 40.42%, it paid a 3.09% yield, and had a recent cost to borrow of 0.868%; shorting it would have netted roughly a 36.5% return.
If we instead use the proposed 2 to 1 ratio, the couple will have higher than minimum volatility and would have netted a 24.3% return. A 4 to 1 ratio would experience even more volatility and would have netted a 29.2% return. And a pure short SQQQ position would have been exposed to its full volatility but netted a 36.5% return.
Risks
Although I believe the probability of it ever happening is quite low, it is always possible that either or both tickers suffer an mechanical problem and fall out of correlation with both their underlying and the other half of the position.
Intentionally weighting more heavily into SQQQ opens one up to a risk from QQQ going down.
The recent annual decay rate of 21.175% was a result of the level of volatility in the NASDAQ-100 Index. If the index experiences a larger number of violent moves, it will decay at a faster erosion rate. Conversely, when the index is more stable, the two funds should decay more slowly and expected returns will be lower.
Although the borrowing fees are presently quite small, they change over time. It is possible that the costs increase significantly, and the coupled position becomes unattractive. While this isn't a big problem if the borrowing rates return to normal quickly, if this happens when one isn't paying attention and borrowing rates stay elevated, this may erode the value of the couple before being noticed.
While the yields are presently quite small, it is possible either of the two begins paying out elevated distributions and the couple enters a period when it becomes significantly less attractive.
Anytime the QQQ enters a strong trend with very few reversions, the strategy is expected to underperform. The QQQ has been in a fairly strong downtrend recently so an example of this can be seen on the 1-Month performance chart above.
Conclusions
Its expected returns of around 18% at a 50/50 weighting is lower than some of the other low-volatility couples I have been looking at.
When looking at the possibility of running the pair SQQQ heavy, expected returns rise but this also opens the position up to more volatility. I believe it would also lessen the benefits one would get from regular rebalancing.
Shorting SQQQ is bullish on the QQQ. In addition to finding itself as part of a low volatility couple, I may find it a home in a portfolio where half the positions are bullish and half are bearish.
I will continue exploring these double-short triple-leveraged pairs trades. I find it attractive that their overall performance is basically uncorrelated with the specific covered call ETFs I have been researching. When the time comes for me to exit the research phase and test out a margin portfolio on a small scale, I will consider this TQQQ SQQQ pairs trade.
For further details see:
TQQQ And SQQQ: Their NAV Erosion Could Be Your Combined Gain