Leveraged Nasdaq 100 Exposure via TQQQ: Worth the Risk? (NASDAQ:TQQQ)

Thesis: TQQQ’s leverage can be a double-edged sword

The ProShares UltraPro QQQ ETF (NASDAQ:TQQQ) offers investors the opportunity to win triple daily returns of the Nasdaq 100. While this can lead to impressive short-term returns in a bull market, I believe it also introduces significant risks that must be managed carefully.

In my view, TQQQ is best used as a tactical investment for short-term trading strategies rather than a long-term holding. The inherent risks associated with leveraged ETFs, such as reduced volatility and daily rebalancing effects, make it unsuitable for buy-and-hold investors.

For those interested in profiting from the performance of the Nasdaq 100, it is essential to understand how the TQQQ works and the potential pitfalls that come with it. In the long term In my opinion, investors should avoid TQQQ.

TQQQ: ETF Profile and Role in a Portfolio

TQQQ attempts to deliver three times the daily performance of the Nasdaq 100. This is achieved through the use of derivatives such as swaps and futures.

The ETF charges an expense ratio of 0.88%, which is significantly higher than its unlevered peers. A common misconception is that a leveraged fund’s expense ratio serves the purpose of covering the cost of leverage (the cost of debt). However, this is not the case, because the cost of the loan is actually taken from the performance of the fund, and not from the expense ratio, which is exclusively what the issuer pockets.

Despite this dynamic, I think the expense ratio of 0.88% is fair given the speculative nature of this fund and industry averages for leveraged ETFs.

Although TQQQ does not own stocks directly, its performance is based on the Nasdaq 100 index, which includes leading technology and development companies such as Apple Inc. (AAPL) and Microsoft Corporation (MSFT).

When comparing TQQQ to the Invesco QQQ Trust (QQQ) and the Invesco NASDAQ 100 ETF (QQQM), it’s clear that the TQQQ is designed for a different type of investor. While QQQ and QQQM provide direct exposure to the Nasdaq 100, TQQQ amplifies that exposure, increasing both potential returns and risks.

I see TQQQ simply as a speculative instrument, intended for investors who are willing to bet on short-term gains in the Nasdaq 100. It is an instrument that is fundamentally inappropriate to hold for the medium to long term in a portfolio, in my opinion. . The reason is partly due to high volatility. But mostly it has to do with the high expense ratio and the volatility decay effect – something I’ll cover in the following paragraphs. These two effects will cause the TQQQ ETF to underperform the Nasdaq 100 over the long term.

Understanding how TQQQ works and an illustrative example

TQQQ’s investment strategy focuses on delivering three times the daily return of the Nasdaq 100. It is important to understand that this leverage is reset daily, meaning the ETF targets three times the performance of the index on a daily basis with day, not for longer periods. This daily reset is a standard feature of leveraged ETFs that helps manage risk and prevent extreme losses over time. In theory, if the Nasdaq 100 dropped 33.3% in a single day, TQQQ could lose all of its capital. However, such a scenario is not only highly unlikely and historically unprecedented, but also virtually impossible due to market mechanisms that halt trading during periods of extreme daily volatility.

The daily rebalancing mechanism is essential for maintaining 3x leverage, but can lead to compounding effects over time, especially in volatile markets. This phenomenon, known as “volatility decay,” can cause the ETF’s performance to deviate from the expected multiple over longer periods.

In bullish market conditions, TQQQ can generate substantial gains in the short term. For example, if the Nasdaq 100 rises 2% in a day, TQQQ aims to provide a 6% return (excluding fees and expenses).

Over long periods, the effects of volatility and daily rebalancing can cause TQQQ’s performance to diverge significantly from three times the index’s return.

As an illustrative example of the volatility decay effect, let’s imagine the following scenario:

1. On day 1 after the investment, the Nasdaq 100 (which I’ll call the “QQQ” for simplicity hereafter) is up 10%. TQQQ increases by 30% (3x).

2. On day 2, QQQ drops by 10%, resulting in a 30% drop in TQQQ.

After the first day, QQQ increases by 10%, so its new value would be 110% of its original value. The 3x leveraged TQQQ ETF would rise 30%, making the investment worth $130.

After day 2, QQQ drops 10% from its new high of 110%, bringing it down to 99% of its original value. The TQQQ ETF is down 30% from its new high of $130, down to $91.

While the Nasdaq 100 was down just 1% from its two-day high (100 to 99), the TQQQ ETF was down 9% ($100 to $91). In other words, the leveraged ETF’s loss is disproportionately greater than the index’s loss due to the compounding of daily returns.

In my opinion, TQQQ is suitable for experienced traders who actively manage their portfolios and can closely monitor positions. Short-term speculators looking to capitalize on short-term market movements could also consider this fund. There is also the case where TQQQ can be used as part of a broader hedging or tactical allocation strategy, for example in conjunction with short positions on QQQ.

For investors looking for exposure to the Nasdaq 100 without the added risks of leverage, I recommend considering QQQM, which I covered in a recent article. This ETF provides exposure to the same underlying index, but without the complexities and risks associated with leverage.

Risks for my thesis

The main counterpoint to my thesis is that during prolonged bull markets and multi-day holding periods, TQQQ can significantly outperform non-leveraged ETFs, even over the long term. In other words, investors who time the market correctly can reap substantial rewards.

This is something that is clearly stated on the TQQQ product webpage:

For any holding period other than one day, your return may be higher or lower than your daily target. These differences can be significant. Lower index gains/losses and higher index volatility contribute to weaker returns than the daily target. Higher index gains/losses and lower index volatility contribute to better returns than the daily target.

Conclusion

The ProShares UltraPro QQQ ETF offers the appeal of higher returns through leveraged exposure to the Nasdaq 100 Index. While this may be tempting, I believe it is important that investors fully understand the associated risks before considering starting an positions.

TQQQ is best suited for short-term trading strategies and should not be considered a core, long-term holding in a portfolio. The complexities of daily rebalancing, lower volatility and higher expenses make it unsuitable for most long-term investors.

Since this isn’t an article about whether or not it’s a good time to get into the Nasdaq 100, I rate this ETF a “HOLD” behind the use cases I described earlier. I advise investors not to hold this fund for a long period of time and do due diligence to understand if it is an instrument they can afford.