The ProShares UltraPro QQQ ETF turned $10,000 into $1.6 million. Could this other ETF be next?

One of the most popular ETFs among investors is ETF ProShares UltraPro QQQ (TQQQ -0.53%)a fund that uses leverage to generate triple the daily returns of the Nasdaq 100. And it’s easy to see why so many people are paying attention: in less than 15 years of existence, it has delivered total returns of more than 16,000% . If you had invested $10,000 in the ETF at its inception in 2010 and reinvested any distributions along the way, you would have more than $1.6 million today.

In short, the fund has enjoyed an exceptional 14-year run for large tech stocks. In addition to the relatively modest bear market in 2022 and a short-lived decline when the COVID-19 pandemic began, Nasdaq it practically grew straight up for years. It was a great time to be index invested with leverage.

While I don’t think this (or any) ETF will replicate this level of performance over the next 14 years, there are good reasons to believe that small-cap stocks are poised for years of performance. And there is a similar ETF that might look interesting to watch.

It might be time for small caps

Small-cap stocks underperformed S&P 500 for over a decade, as mega-cap tech stocks have disproportionately fueled stock market performance. In fact, the average stock in the Russell 2000 Small-Cap Index trades for a book-to-book valuation that is less than half that of the S&P 500 average component.

With the Federal Reserve set to cut rates for the first time since 2020, it could create a positive environment for small caps. For example, small caps tend to be faster-growing businesses and often use more leverage (debt) than their large-cap counterparts, so falling rates can create a favorable cost of capital.

There’s a leveraged ETF for that…

There is an ETF called Direxion Daily Small Cap Bull 3X Stocks (TNA 1.99%)which aims to deliver three times the daily performance of the Russell 2000 Index, which is generally considered the most comprehensive index of US small-cap stocks.

It is similar in structure to the ProShares UltraPro QQQ ETF. It leverages 3x daily, has a similar expense ratio and tracks the most widely used benchmark for its target stock type. However, the results were very different.

Math is not your friend with leveraged ETF investing

The biggest problem with leveraged ETF investing is that because they aim to produce three times the daily return on an index, the math doesn’t favor long-term investors.

Consider this simplified example. Let’s say that during a market crash, the Russell 2000 loses 10% on one day, 10% on the next day, and another 10% on the third day. A $1,000 investment in a standard Russell 2000 ETF could drop to about $729 after this sequence of events. Then you would need a 37% return to get back to your original $1,000.

On the other hand, a Russell 2000 ETF with 3X leverage would drop 30% every day. After the three-day crash, your $1,000 investment would be worth only $343. The ETF should now rise 192% only to get back to even.

Of course, this is an extreme and hypothetical example, but the math makes leveraged ETFs underperform over time (the Nasdaq leveraged ETF is a rare exception).

A look at the real-world numbers tells the story. Over the past 10 years, the Russell 2000 has produced an annualized total return of 7%. You might expect the Direxion Daily Small Cap Bull 3X stock to have delivered somewhere in the neighborhood of 21% total returns, but you’d be very wrong. The leveraged ETF’s annualized total return over the past decade is negative-0.6%.

Should you invest?

It’s important to remember that leveraged investing in ETFs is a highly speculative practice and can go very wrong, very quickly. If the Russell 2000 goes the wrong way, it will increase your losses dramatically. Investors who simply want a set-it-and-wait-it way to add small-cap exposure to their portfolio would be better off with a core (non-leveraged) ETF such as Vanguard Russell 2000 ETF (VTWO 0.64%).

If you think small-cap stocks are in a good position to outperform in the coming years, there’s nothing wrong with making a small speculative investment in a leveraged ETF if you know that’s what you’re doing — speculating. But keep in mind that leveraged ETFs can be quite volatile, and it’s not unheard of for investors to lose most, or even all, of their money if things go wrong.