The Mysterious World of Leveraged ETF Investing

I have been doing some homework on how daily rebalancing of leveraged ETFs works. It is a surprisingly mysterious process. Suppose that the fund has equity of $100m. Let us see how it works in practice. Three times leverage means that $100m of equity is used to buy $300m of shares.

Now imagine that the fund rises by one per cent or $3m to $303m. This will add $3m or three per cent to the value of the underlying equity; that is how leverage works.

But now we have a problem because in order to maintain the three times leverage the fund needs to be three times $103m which is $309m but it has only risen one per cent to $303m. This means that the managers have to add an additional $6m of exposure.

This happens every time the fund rises so in a rising stock market the original three times gearing is compounded over time. This explains why over a long period the fund can outperform the underlying index by much more than three times as happened between 2012 and 2021.

Between 2012 and the peak in 2021 QQQ, the unleveraged Nasdaq 100 tracker, rose roughly eightfold from $50 to $409. Over the same period QQQ3, the three times leveraged version, rose not 24-fold, as would have been indicated by the three times leverage but 91 times from $3 to $274.