TQQQ: Volatility Spike and Updated Leverage Rating (NASDAQ: TQQQ)

Massimo Giachetti/iStock Editorial via Getty Images

Investment thesis

My latest coverage on the ProShares UltraPro QQQ ETF (TQQQ) was published on July 2, 2021. The article details how I use TQQQ to apply leverage to our aggressive growth portfolio. The keys of this method are double. First, the leverage is dynamically adjusted. In other words, we will apply different levels of leverage in different market conditions to maximize our return. The second key is that the method helps us to stay disciplined. Discipline is absolutely crucial to using long-term leverage. And the essence of the idea is to take on less debt when volatility (measured by the VIX) increases. And vice versa, to exploit more when the VIX decreases.

Such a dynamic and disciplined approach has rewarded us well in the past. As you can see from the following charts, TQQQ has returned 22% at the time of this writing since July 2, 2021. And the maximum return has been over 42% during this period. The low volatility (VIX around 15) in July indeed served as a leading indicator to use more leverage – in line with longer-term historical data (to be elaborated on later). Such large price increases and the role of volatility as a leading indicator have resulted in a systematic generation of alpha.

However, with the recent spike in volatility as seen below, it is time to reassess the situation. And the main takeaway is that you should consider reducing your exposure to TQQQ (we’ve reduced our exposures ourselves), and it’s even more important for investors to stay disciplined with the use of TQQQ, especially in uncertain times like this.

Chart TQQQ

Chart TQQQ

Source: Yahoo Finance

How do we use TQQQ and why have we reduced our exposure now?

Here’s a quick recap of the main ideas to help with the rest of the update, and interested readers can check out my previous wiring if further clarification is needed. The idea of ​​using more leverage when volatility is low has also been discussed and tested extensively elsewhere (e.g. see “Alpha Generation and Risk Smoothing Using Managed Volatility” by Tony Cooper and a tutorial of the method here).

The Leveraged Model Portfolio is a variation of Ray Dalio’s All-Weather Portfolio (“AWP”), a variation that uses systematic leverage to enhance growth. The portfolio consists of:

  • About 10% gold
  • Approximately 15% mid-term bonds and approximately 20% long-term bonds
  • Exact gold and bond allocations are adjusted based on the ratio of the price of gold to the S&P 500 index and the relative valuation of bond yield and stock yield.
  • And the rest is invested in stocks and leverage is applied to stock holdings. Leverage is applied to equity holdings by holding a leveraged fund. In the backtest I’ll show later, I used ProShares Ultra S&P500 (SSO) (a 2x leveraged S&P 500 fund) because of its longer track record so I could backtest more scenarios. In my current take, I sometimes use TQQQs or CEFs. The relative weight of the leveraged fund has been dynamically adjusted according to 6/VIX, where VIX is the CBOE volatility index. So, for example, when VIX = 24, the equity allocation would consist of 25% TQQQ and 75% unleveraged equity.

Based on the above, since volatility is so low in July, leverage then started at 8.6% of the TQQQ allocation. And then it declined to the current level of 6.4%, a 25% reduction in exposure as you can see in the following chart. Also, I don’t often rebalance my portfolio to minimize turnover and effort (and tax consequences on my taxable accounts). I rebalance my portfolio monthly in the middle of each month. So that’s why you see the changes in the TQQQ allocation as it appears in the chart.

Weight of TQQQ in the leveraged portfolio

Source: author

The following table presents an update of the allocation of all asset classes in this portfolio. As you can see the main changes are;

  1. Again, a 25% reduction in TQQQ exposure from 8.6% to 6.4% as mentioned above.
  2. A slight increase in unleveraged equity exposure from 43.7% to 44.8%. Therefore, we basically increased our exposure to equities without leverage and only reduced our leverage.
  3. A slight increase in bond allocations, consisting of a 2.8% increase in the intermediate bond allocation and a 1.3% decrease in the long-term bond allocation. And the reason for this change is that the increase in stock valuation (or the decrease in stock yield) is greater than the decline in bond yield. As a result, there is a slight shift towards bonds because, as mentioned above, bond allocation depends on the relative valuation of bond yields and equity yields.
  4. There is no change in the gold allocation.

Leveraged Model Portfolio Update

Source: author

Performance Update

The performance of the leveraged portfolio on a weekly basis since May is summarized in the following two charts, compared to the VTI as a representation of the total market. Although this was very short compared to my horizon and there is no need to read too much into the specific numbers. As of this writing, the portfolio leads the overall market by a small margin (about 0.5%), which could change with a day or two of random market fluctuations. However, you can already see its leveraged nature. It outperforms the broader market in general due to the systematic use of leverage, especially during major stock market rallies like what has happened in the last ~6 months. It also fluctuated less due to good diversification and disciplined allocation, as we will see later.

Portfolio growth since inception

Source: author.

Comparison of return on investment since launch

Source: author

The result of the backtest over a period of 15 years, from 2006 to 2020 (the SSO was created in June 2006), is presented below. As you can see, the backtest compared the leveraged AWP method to the original AWP and the S&P 500 (represented by the Vanguard 500 index fund). The portfolio was adjusted monthly, the yield included the dividend and the leverage factor was 6/VIX. The leveraged AWP has outperformed both the AWP and the S&P 500 most of the time, and really took off and started dominating them soon after the big crash of 2008 ended. , the leveraged AWP has outperformed both the AWP and the S&P 500 by a significant margin during this period (CAGR of 14.45% versus around 8%). The table below gives a more detailed overview. As seen, the leveraged AWP also provided lower risks, measured by standard deviation, worst loss of the year, Sharpe ratio, Sortino ratio, et al. It only suffered a maximum drop slightly lower than the AWP (-30.6% vs. -27.02%), but still significantly better than the S&P 500 (-50.97%).

Chart TQQQ

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

AWP and Vanguard 500 results

Source: Author, with simulator from Portfolio Visualizer, Silicon Cloud Technologies LLC

Risks

Both using TQQQ itself and using the leveraged approach above carry risks. And some of the main ones are detailed below.

First, for TQQQ itself, the main risks I see are its valuation risk, ongoing macroeconomic uncertainties (e.g. COVID, inflation, interest rates, etc.), as well as geopolitical uncertainties (for example, the Chinese housing bubble). The underlying index valuation of TQQQ is around 34x PE (taken as the PE ratio of the QQQ fund provided by Yahoo Finance). To put things in perspective, the following chart shows the current and historical PE ratio of the Nasdaq index from 2006 to 2021. And as seen, the PE of the Nasdaq index currently sits at around 27.9, the highest level since 2006 when excluding outliers during 2017 due to sudden changes in income. Such a combination of high valuation and high degree of uncertainty calls for both caution and discipline.

TQQQ PE Report

Source: Macrotrends

Using leveraged funds like TQQQ involves several risks, its own risks as well, including but not limited to the risks of total loss, fee slippage and dividend slippage. If you hold TQQQ, a daily crash of 33.3% would result in a total loss as it is 3x leveraged. With fees of around 0.9%, holding TQQQ also creates a fee trail compared to fees of around 0.2% for non-leveraged ETFs like QQQ. And finally, TQQQ, as a leveraged fund, does not pay dividends, thus creating dividend leverage as well. In the end, the added benefit of using leverage may or may not be enough to overcome these risks.

Conclusions and final thoughts

My previous article described a method for achieving aggressive growth through the disciplined and dynamic use of TQQQ. This article provides an updated analysis given TQQQ’s significant gain since then and the recent spike in volatility. The main takeaways are:

  1. Historical data suggests that volatility serves as a leading indicator for future returns. Based on this understanding, a dynamic and disciplined approach has rewarded the leveraged portfolio in the past, both in the short term and longer term.
  2. With the recent spikes in volatility, it’s time to consider taking profits – if you haven’t – and reducing your exposure to TQQQ. We ourselves have reduced our exposures. In times of uncertainty like this – with a historically high stock market valuation and several major macro uncertainties – it is even more important for investors to remain disciplined, especially with the use of leveraged funds like TQQQ.
  3. Even though I used SSO in the backtest (due to its longer history so I can backtest more scenarios), I actually use TQQQ or CEF sometimes in practice. I prefer TQQQ to SSO for two main reasons. First, it has better liquidity. And second, TQQQ provides 3x leverage. As a result, I could hold less leveraged assets in absolute dollar amount and achieve the same level of leverage, which helps reduce fee drag, dividend drag and also reduce my amount absolute in dollars exposed to leverage.