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.
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The mathematics on the way down is equally complicated because when the fund is falling the asset base becomes more than three times and exposure has to be reduced to maintain the three times daily leverage.
Let us look at what happened between November 2021 and the recent low point. QQQ fell from a peak $408 to a low of $254. This is a decline of 37.7pc. Over the same period QQQ3 fell from a peak $274 to a low of $47.86. This is a decline of 82.5pc.
Maths was never my strong point at school but I think this means that on the way down the daily rebalancing has the effect of softening the three times leverage. Three times 37.7pc is over 100pc or total wipeout but that didn’t happen.
Charts don’t lie
I think it is fair to assume that charts don’t lie. If we look at a chart of QQQ3 we can see what happens to the price over time and that suggests that it is an investment which can work for long-term investors. What is clearly required is patience and this ties in with Warren Buffett’s famous observation that the stock market is a mechanism for transferring wealth from impatient investors to patient investors, people like him.
I sadly am an impatient investor. I know that I shouldn’t be but will I ever learn.
I have done some background calculations on a spread sheet and as far as I can tell if you keep investing, say every three months as per each candlestick on this chart, you would never be out of money for long and, I suspect would be poised to do well from here on.
A new 3m buy signal
We are on the brink of a new golden cross buy signal on this chart and on past form that should prove an excellent time to buy. There have been two previous buy signals, both of which worked very well and if we could project them backwards I am sure there would have been a third buy signal near the beginning of the chart.
This means the current buy signal (if it is confirmed by the red line longer term moving average turning higher) will be the third or the fourth in a decade so they don’t happen very often. If we are in for a good period in the stock market then the compounding effect will work in your favour to add to the gains from three times leverage.
Shares in QQQ3 have suffered their worst correction since the fund was created in December 2012. There has been nothing like this before with a peak to trough decline over 80pc. It resembles what happened to the Nasdaq 100 index after the Internet bubble peak in 2000 when the index fell by a similar 83.6pc, peak to trough.
Golden cross on the Nasdaq 100
The turnaround was signalled by a golden cross on the 3m candlestick chart. We have another such buy signal currently.
Late 2003 was an excellent time to buy technology shares although there was another brutal bear market to come in 2008-09. It makes me think that the odds favour the bulls from now on with QQQ3, especially since sentiment towards shares is still fragile. We want a wall of worry for bull markets to climb and that is what we have.
What we don’t yet have is a strong advance by QQQ3. There is more a feeling of convalescence about the way the shares are behaving but I believe the advance will come and will be an exciting period for holders of these shares.
Wisdomtree Nasdaq 100x daily leveraged ETF. QQQ3. Buy @ $87