Beware Time-Decay Of TQQQ. SSO And QLD Are Better Long-Term Investment (2024)

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Introduction

Leveraged ETFs use financial derivatives and debt to amplify the returns of an underlying index (benchmark), often aiming for a 2X or 3X return of the underlying index. Despite the magnified return or loss, the leveraged ETFs are known to suffer from time-decay, which may be caused by transaction expenses, managing cost, interest expense of debts, etc. As a consequence, the long-term returns of leveraged ETF are often much less than the expected 2X or 3X returns. It is generally recommended that the leveraged ETFs be used as short-term trading vehicles, rather than as long-term investment options. However, despite the recommendation, some investors have claimed to use them as long-term investment tools on social media.

Mathematically the average decay d over time can be approximated by the equation below where β stands for the fold of leverage (2X or 3X), and σ the average volatility of the benchmark: However, this equation is an approximate estimate of average daily decay based on averaged volatility in a period. It does not capture the accurate value of decay on each day, nor does it provide any insight on how the daily decay is correlated with the daily return of the benchmark. In this analysis, I will take a close look at the historical daily decays of three popular leveraged ETFs, and compare the cumulative decay with gain potential over the long term to provide insight as to whether they are good longer-term investment vehicles.

Objective

This work aims to take a closer look at the daily decay of three leveraged ETFs namely ProShares Ultra S&P500 (SSO) (2X for S&P500 SPX), ProShares Ultra QQQ (QLD) (2X for NASDAQ-100 NDX), and ProShares UltraPro QQQ (TQQQ) (3X for NASDAQ-100 NDX), and compare their performance in comparison to their benchmarks over a long term. The cumulative time-decay and the potential gain over longer-term were compared in order to provide insight as to whether these leveraged ETFs are appropriate for a longer-term investment choice.

Conclusions

The leveraged ETFs do have significant decays and the majority of the decay occurred during the bear market. During the prolonged bull market, the decay was quite small for the 2X leveraged ETFs such as SSO and QLD in comparison to the potential upside gains. Therefore, for a long-term investor, it is a viable strategy to hold 2X leveraged ETFs for a long term (years) if one can somehow avoid the bear market. Since a market drop of >25% was infrequent and has happened on average once in 10 years since 1920, it is a viable strategy to hold a leveraged 2X ETF for 1-2 years after the market recovers from a significant drop like in 2008 and in 2020. The 3X leveraged ETFs such as TQQQ have much higher time-decay in comparison to 2X ETFs and are less desirable for long-term holding.

Results and Discussions

Based on ETFs' historical prices in comparison to those of the corresponding benchmarks, the daily decay can be calculated as the end-of-day deviation between the observed price of the leveraged ETF and the expected 2X or 3X price based on the daily return of the benchmark.

As shown in Figure 1, the calculated daily decay of SSO varies significantly each day and was more pronounced during the bear market. It is also interesting to observe that in the prolonged bull market between 2012 and 2017, the average decay was slightly positive; which, the author speculates, might be attributed to the ETF's slightly over-leverage. In addition, there seemed to be a correlation between the benchmark SPX daily return and the daily decay of leveraged ETF SSO (Figure 2). On days of high market volatility (large up or down days), the variability of daily decay for SSO was much larger, and the decay seems the worst on strong up days, most of which seemed to occur during bear market dead-cat-bounce. The mean and standard deviation of daily decay for SSO, QLD, and TQQQ were shown in Table 1. The mean daily decay was lowest for SSO, and as expected highest for TQQQ (more than 4-fold higher than SSO). Therefore it appears TQQQ is less desirable for long-term holding.

Table 1. The mean and standard deviation of daily decay for SSO, QLD, and TQQQ. Dates are expressed in YYYY-MM-DD format.

Author, analyses conducted with data from Yahoo Finance.

Figure 1. Daily decay and a 20-day simple moving average of daily decay of SSO versus time (red horizontal line indicates 0)

Author, analyses conducted with data from Yahoo Finance

Figure 2. Correlation between SSO daily decay and SPX daily return (from 2006-06-22 to 2020-12-17). Red dotted line: LOWESS curve

Author, analyses conducted with data from Yahoo Finance

Since the amount of decay is not even across different periods, I then looked into different representative periods of the market and see how each of the leveraged ETFs performed during those periods (Table 2). These periods are representative of different market stages: bear market downturn e.g. 2007-10-01/2009-03-06, bear market recovery, e.g. 2009-03-06/2012-03-27, as well as long-term market consolidation, e.g. 2018-01-26/2020-05-11. Overall SSO has the least amount of decay, averaging -0.004% daily since inception while TQQQ averages -0.027% daily, a whopping seven-fold that of SSO. QLD was in between and averaged -0.013% decay daily. Also please note that the decays vary with time, agreeing with the equation mentioned above. The bear market of 2020 had the highest daily decay in all three ETFs, about five- to six-fold the daily decay during the 2007 bear market. During the 2020 bear market, TQQQ's decay amounted to a whopping 28% while those for SSO and QLD were around 10%. During the bull market correction in 2020 between Sept and Nov, TQQQ's decay accounted for a 7% loss, while SSO's decay was only 0.7% loss. Figure 3 illustrated the magnitudes of decay of the leveraged ETFs in contrast to the benchmarks during the two recent bear market 2007 and 2020. Given the obviously much higher decay for TQQQ in both the bear and bull markets, TQQQ is not a desirable vehicle for long-term holding.

Table 2. Comparison of returns of benchmark indexes and the leveraged ETFs, and the decays in different periods of market fluctuation. Dates are expressed in YYYY-MM-DD format.

Author, analyses conducted with data from Yahoo Finance

Figure 3. Price overlay of leveraged ETFs (SSO and QLD) with the benchmark in the two recent bear markets. Y-axis showing price of the leveraged ETFs

Author, analyses conducted with data from Yahoo Finance

For leveraged ETFs, it is sometimes cited that the leveraged ETFs lose money because the underlying strategy of such ETFs requires it to increase the market exposure when the price moves up and reduce exposure when the market moves down. Therefore they constantly buy high then sell low. The analysis showed that the strategy itself was not the major issue for leveraged ETF. Assuming no decay, the leveraged ETF such as SSO would have produced approximately 2X the return of the benchmark and would not suffer much loss going through the two major bear markets (2020-02-19/2020-08-21 and 2007-10-01/2012-03-27) or during the prolonged 2-year consolidation from 2018 to 2020 (Table 2, last column). The decay, on the other hand, is a more serious problem and accounted for almost all the under-performance of the leveraged ETFs during the bear market.

Since the observed data for most leverage ETFs are rather limited due to their recent inception, it was impossible to evaluate their long-term performance (since 1920). Using bootstrap, the daily price history of the leverage ETFs since 1920 can be simulated based on their current price, the daily decay correlated with the daily return of the benchmark, as well as the price history of the benchmark (Figure 3). Based on the simulation, if TQQQ had inception before the 2000 dot-com bubble, it would not have recovered all the loss even till today, due to the significant decay it would have suffered during the downturn from 2000 to 2002.

Figure 4. Simulated leveraged ETF (SSO QLD and TQQQ) price and 90% confidence interval (CI in blue) overlay with the observed price (orange) and normalized benchmark price (SPY, NDX, and NDX in red for comparison)

Author, analyses conducted with data from Yahoo Finance

To decide whether a leveraged ETF could be held for a longer term, one needs to consider both the magnitude of the decay, as well as the potential upside. No leverage comes free and the decay can be viewed as the cost of the leverage. The answer hinges not only on whether the decay exists but also on the potential upside and whether the trade-off is worthwhile based on individual investor's risk tolerance.

Since the market made the 2020 March bottom, there was lots of suspicion as to how much longer the market can continue to go up, and whether the leveraged ETFs such as SSO can be held for a longer term. Using the simulated SSO data we can summarize the 10 incidences since 1920, when the market dropped more than 25%, then recovered and reached a historical high (Table 3). The simulated SSO gain and SPX gain after hitting the bottom in these 10 incidences were compared side by side, along with the cumulative decay of SSO in those periods. It was interesting that the simulated cumulative decays were less than -10% in all cases, and in some cases, the decays were even slightly positive, most likely owning to resampling of the observed slightly positive daily decay data during the prolonged bull market from 2012 to 2017 (Figure 1). On the other hand, the SSO gains in the 10 incidences were quite remarkable in comparison to SPX, with a median gain of 445% for SSO and 145% for SPX.

Table 3. Historical performances of SSO after SPX made a >25% drop, then recovered to a new high. Dates are expressed in YYYY-MM-DD format

Author, analyses conducted with data from Yahoo Finance

Figure 5. Normalized SSO performance 800 trading days from the market bottom

Author, analyses conducted with data from Yahoo Finance

Actionable takeaways

Based on the research shown in this article, 2X ETFs such as SSO and QLD are good investment vehicles during the bull market. Since after a 25% drop, the following bull market tends to go for years instead of months (median bull market 455 trading days, or >2yrs), if you have bought into the market weakness in 2020, you can continue to hold these 2X ETFs for another year or so.

3X ETFs such as TQQQs have much higher decay, and the loss from time-decay is significant in both the bear and bull markets. Therefore TQQQ is not a desirable vehicle for long-term holding.

Acknowledgements

The author would like to thank Lisha Chen and Xinfeng Zhou for their help in editing this article.

I am a modeling and simulation expert in the area of pharmaco*kinetics and pharmacodynamics. I am an individual investor and I apply modeling and simulation techniques in market research and exploration of investment strategies.