TQQQ has grown in popularity after a decade-long raging bull market for large cap growth stocks and specifically Big Tech. But is it a good investment for a long term hold strategy? Let’s dive in.
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What Is TQQQ?
Explaining how a leveraged ETF works is beyond the scope of this post, but I delved into that a bit here. Basically, these funds provide enhanced exposure without additional capital by using debt and swaps. This greater exposure usually comes at a pretty hefty cost, in this case an expense ratio of 0.95% at the time of writing. The “normal” 1x fund QQQ has an expense ratio of about 1/5 that at 0.20%.
These funds are typically used by day traders, but recently there seems to be more interest in holding them over the long term.
But What About Volatility Decay?
The daily resetting of leveraged ETFs means the fund only provides the return multiple relative to the underlying index on a daily basis, not necessarily over the long term. Because of this, volatility of the index can eat away at gains; this is known as volatility decay or beta slippage.
Unfortunately, the financial blogosphere took the scary-sounding “volatility decay” and ran with it to erroneously conclude that holding a leveraged ETF for more than a day is a cardinal sin, ignoring the simple underlying math that actually helps on the way up. In short, volatility decay is not as big of a deal as it’s made out to be, and we would expect the enhanced returns to overcome any volatility drag and fees.
Drawdowns Are Important
I’m not one to parrot the “leveraged ETFs can be wiped out” idea (thanks to modern circuit breakers), but if QQQ drops by 5%, TQQQ drops by 15%. People tend to focus on volatility decay and forget that major drawdowns are actually the bigger concern here. This is because simple math again tells us that it requires great gains to recover from great losses:
As a simplistic example using dollars, suppose your $100 portfolio drops by 10% ($10) to $90. You now require an 11% gain to get back to $100.
100% TQQQ Is Not A Good Investment for a Long Term Hold Strategy
The graph above illustrates in theory why a 100% TQQQ position is not a good investment for a long term hold strategy.
Many are jumping into TQQQ after seeing the last decade bull run of large cap growth stocks, as TQQQ has only been around since 2010 and is up over 5,000% from then through 2020:
Looks great, right? Not so fast. This is called recency bias – using recent behavior to assume the same behavior will continue into the future. As we know, past performance does not indicate future performance. Moreover, a decade – especially one without a major crash – is a terribly short amount of time in investing from which to draw any sort of meaningful conclusions.
TQQQ vs. QQQ
So we need to go back further to get a better idea of how TQQQ performs through major stock market crashes, which we can do by simulating returns going back further than the fund’s inception. Going back to 1987 for TQQQ vs. QQQ tells a somewhat different story:
Notice how if you buy and hold TQQQ alone, it is basically a timing gamble that depends heavily on your entry and exit points. Basically, it can take too long for the leveraged ETF to recover after a major crash. After the Dotcom crash of 2000, TQQQ didn’t catch up to QQQ until late 2007 right before it crashed again in the Global Financial Crisis of 2008. Had you bought in January 2000 right before the Dotcom crash, you’d still be in the red today:
So far I haven’t even touched on the psychological aspects of this idea. Most investors severely overestimate their tolerance for risk and can’t stomach a major crash with a 100% stocks position, much less a 300% stocks position. Holding TQQQ through the Dotcom crash would have seen a near-100% drawdown.
A Viable Strategy for Long Term TQQQ – Use Bonds with TMF
The above graphs tell us 100% TQQQ is only a viable strategy if we can perfectly predict and time the market, which we know is basically impossible.
So how can we make it work? By using a hedge to mitigate those harmful drawdowns. Diversification is your friend with leveraged ETFs. Treasury bonds offer the greatest degree of uncorrelation to stocks of any asset. I explained here why you shouldn’t fear them. TMF is a very popular leveraged ETF for long-term treasury bonds. This is the same basis of the famous Hedgefundie Strategy. This idea is also extended with other assets like gold in my leveraged All Weather Portfolio.
Once again, the beautiful 60/40 portfolio – in this case 3x for 180/120 exposure – emerges as the best option (at least historically) in terms of both general and risk-adjusted returns:
While we expect lower bond returns in the future, it doesn’t mean TMF won’t still do its job. Think of it as a parachute insurance policy that bails you out in stock crashes.
Also remember the NASDAQ 100 is basically a tech index, posing a concentration risk, and growth stocks are looking extremely expensive in terms of current valuations, so they now have lower future expected returns. For these reasons, I’m a fan of using UPRO instead (the Hedgefundie strategy).
Addressing Concerns Over Bonds
I’ve gotten a lot of questions about – and a lot of the comments in discussions on TQQQ strategies focus on – the use, utility, and viability of long-term treasury bonds as a significant chunk of this strategy. I’ll briefly address and hopefully quell these concerns below.
Again, by diversifying across uncorrelated assets, we mean holding different assets that will perform well at different times. For example, when stocks zig, bonds tend to zag. Those 2 assets are uncorrelated. Holding both provides a smoother ride, reducing portfolio volatility (variability of return) and risk.
Common comments nowadays about bonds include:
- “Bonds are useless at low yields!”
- “Bonds are for old people!”
- “Long bonds are too volatile and too susceptible to interest rate risk!”
- “Corporate bonds pay more!”
- “Interest rates can only go up from here! Bonds will be toast!”
- “Bonds return less than stocks!”
So why long term treasuries?
- It is fundamentally incorrect to say that bonds must necessarily lose money in a rising rate environment. Bonds only suffer from rising interest rates when those rates are rising faster than expected. Bonds handle low and slow rate increases just fine; look at the period of rising interest rates between 1940 and about 1975, where bonds kept rolling at their par and paid that sweet, steady coupon.
- New bonds bought by a bond index fund in a rising rate environment will be bought at the higher rate, while old ones at the previous lower rate are sold off. You’re not stuck with the same yield for your entire investing horizon.
- We know that treasury bonds are an objectively superior diversifier alongside stocks compared to corporate bonds. This is also why I don’t use the popular total bond market fund BND. It has been noted that this greater degree of uncorrelation between treasury bonds and stocks is conveniently amplified during periods of market turmoil, which researchers referred to as crisis alpha.
- Again, remember we need and want the greater volatility of long-term bonds so that they can more effectively counteract the downward movement of stocks, which are riskier and more volatile than bonds. We’re using them to reduce the portfolio’s volatility and risk. More volatile assets make better diversifiers. Most of the portfolio’s risk is still being contributed by stocks.
- This one’s probably the most important. We’re not talking about bonds held in isolation, which would probably be a bad investment right now. We’re talking about them in the context of a diversified portfolio alongside stocks, for which they are still the usual flight-to-safety asset during stock downturns. Specifically, in this context, the purpose of the bonds side is purely as an insurance parachute to bail you out in a stock market crash. Though they provided a major boost to this strategy’s returns over the last 40 years while interest rates were dropping, we’re not really expecting any real returns from the bonds side going forward, and we’re intrinsically assuming that the stocks side is the primary driver of the strategy’s returns. Even if rising rates mean bonds are a comparatively worse diversifier (for stocks) in terms of future expected returns during that period does not mean they are not still the best diversifier to use.
- Similarly, short-term decreases in bond prices do not mean the bonds are not still doing their job of buffering stock downturns.
- Historically, when treasury bonds moved in the same direction as stocks, it was usually up.
- Interest rates are likely to stay low for a while. Also, there’s no reason to expect interest rates to rise just because they are low. People have been claiming “rates can only go up” for the past 20 years or so and they haven’t. They have gradually declined for the last 700 years without reversion to the mean. Negative rates aren’t out of the question, and we’re seeing them used in some foreign countries.
- Bond convexity means their asymmetric risk/return profile favors the upside.
- Again, I acknowledge that post-Volcker monetary policy, resulting in falling interest rates, has driven the particularly stellar returns of the raging bond bull market since 1982, but I also think the Fed and U.S. monetary policy are fundamentally different since the Volcker era, likely allowing us to altogether avoid runaway inflation environments like the late 1970’s going forward. Bond prices already have expected inflation baked in.
“The purity of noncallable, long-term, default-free treasury bonds provides the most powerful diversification to investor portfolios.”
Ok, bonds rant over. If you still feel some dissonance, the next section may offer some solutions.
Reducing Volatility and Drawdowns and Hedging Against Inflation and Rising Rates
It’s unlikely that any of the following will improve the total return of a strategy like this, and whether or not they’ll improve risk-adjusted return is up for debate, but those concerned about inflation, rising rates, volatility, drawdowns, etc., and/or TMF’s future ability to adequately serve as an insurance parachute, may want to diversify a bit with some of the following options:
- LTPZ – long term TIPS – inflation-linked bonds.
- FAS – 3x financials – banks tend to do well when interest rates rise.
- EDC – 3x emerging markets – diversify outside the U.S.
- UTSL – 3x utilities – lowest correlation to the market of any sector; tend to fare well during recessions and crashes.
- YINN – 3x China – lowly correlated to the U.S.
- UGL – 2x gold – usually lowly correlated to both stocks and bonds, but a long-term expected real return of zero; no 3x gold funds available.
- DRN – 3x REITs – arguable diversification benefit from “real assets.”
- EDV – U.S. Treasury STRIPS.
- TYD – 3x intermediate treasuries – less interest rate risk.
What About DCA / Regular Deposits?
The backtests above buy and hold TQQQ with a starting balance of $10,000 and no additional deposits. Some will point out that an investor will usually be regularly depositing into the portfolio and that this would change the results. Since the market tends to go up and since major crashes are typically infrequent, regular deposits of $1,000/month actually doesn’t change the end result:
TQQQ/TMF Pie for M1 Finance
You’ll need to rebalance a strategy like this regularly. I used quarterly rebalancing in the backtest above. You might want to use M1 Finance to implement this type of strategy, as the broker makes rebalancing extremely easy with 1 click, and they even feature automatic rebalancing through which new deposits are directed to the underweight asset. I wrote a comprehensive review of M1 here.
Don’t buy and hold TQQQ – or any leveraged stocks ETF – “naked” for the long term without a hedge of some sort, because sometimes they simply can’t recover from major drawdowns. The last decade has looked great for TQQQ, but don’t succumb to recency bias.
TMF is likely the most suitable hedge for funds like TQQQ and UPRO. For those with a weaker stomach who still want to use leverage, check out my discussion on levering up the All Weather Portfolio.
Do you use TQQQ in your portfolio? Let me know in the comments.
Disclosure: I am long UPRO and TMF in my own portfolio.
Disclaimer: While I love diving into investing-related data and playing around with backtests, I am in no way a certified expert. I have no formal financial education. I am not a financial advisor, portfolio manager, or accountant. This is not financial advice, investing advice, or tax advice. The information on this website is for informational and recreational purposes only. Investment products discussed (ETFs, mutual funds, etc.) are for illustrative purposes only. It is not a recommendation to buy, sell, or otherwise transact in any of the products mentioned. Do your own due diligence. Past performance does not guarantee future returns. Read my lengthier disclaimer here.