Leveraging a Growing Segment of Nasdaq-100 Funds
- By Leks Gerlak, CFA
- The $73 billion Invesco QQQ ETF, tracking the Nasdaq-100 Index, surpassed its 20th anniversary earlier this year.
- Since QQQ launched in March 1999, the Nasdaq-100 Index has outperformed the S&P 500 by 1.35% annualized (as of August 31, 2019).
- Growth in leveraged and inverse mutual funds and ETFs tracking the Nasdaq-100 hit an inflection point in 2017, when assets skyrocketed from $3.9 billion to $6.2 billion. Increased interest continues to build in this market environment, with both bulls and bears positioning for what’s next.
The $73 billion Invesco QQQ ETF, tracking the Nasdaq-100 Index, celebrated 20 years in early March. The Nasdaq-100 Index, which includes 100 of the largest domestic and international non-financial companies listed on the Nasdaq Stock Market based on market cap, provides exposure to some of the most innovative companies in the world. Since QQQ launched in March 1999, a year before the dot-com bubble, the Nasdaq-100 Index has outperformed the S&P 500 by 1.35% annualized (7.46% vs. 6.11%) as of August 31, 2019. That amounts to a cumulative return of 336% vs 237% for the S&P 500. Not surprisingly, the interest and investment options in the Nasdaq-100 have grown significantly over the past 20 years.
Source: Morningstar, 3/10/1999 – 8/31/2019. The performance quoted represents past performance and does not guarantee future results. Investment comparisons are for illustrative purposes only and not meant to be all-inclusive. Index performance does not reflect any management fees, transaction costs, taxes or expenses. Indexes are unmanaged and one cannot invest directly in any index.
Leveraged and Inverse Nasdaq-100 Strategies
When we look at the performance history of the Nasdaq-100 since the inception of QQQ, it’s clear that it has had more juice than the S&P 500. Over the past 20 years, the Nasdaq-100 has had a beta of 1.37 relative to the S&P 500, and the Nasdaq-100’s volatility has been notably higher than the S&P 500’s at 24.2% vs. 14.6% (as of August 31, 2019). Volatility is a core factor in understanding returns of leveraged and inverse strategies, and this will be highlighted later on in the review of compounding.
Leveraged and inverse mutual funds tracking the Nasdaq-100 launched in 1997/1998, about a year before QQQ, and leveraged and inverse Nasdaq-100 ETFs entered the market in 2006. The use of these types of funds has expanded greatly since. In fact, the growth in Nasdaq-100 leveraged and inverse funds hit an inflection point in 2017. Assets skyrocketed from $3.9 billion to $6.2 billion, largely driven by a 3x leveraged ETF. Not so coincidentally, 2017 was a year where stocks steadily marched higher with very low volatility throughout the year. 2017 was also a notable year for the Nasdaq-100, as the index strongly outpaced the S&P 500 (33.0% vs. 21.8%). Since then, interest and activity in leveraged and inverse Nasdaq 100 strategies has increased, and there’s now nearly $9.0 billion in these types of funds.
Source: Morningstar, 2/2008 – 8/2019. Asset data shown using monthly values for leveraged and inverse Nasdaq-100 daily objective mutual funds and ETFs. Performance quoted represents past performance and does not guarantee future results. Investment comparisons are for illustrative purposes only and not meant to be all-inclusive. To better understand the similarities and differences between investments, including investment objectives, risks, fees, and expenses, it is important to read the products’ prospectuses. For both standardized fund performance and fund return data current to the most recent month’s end, visit Performance.
Understanding Compounding with Leveraged and Inverse Funds
The vast majority of leveraged and inverse funds have a one-day investment objective. That is, they aim to provide a multiple, inverse or inverse multiple of the return of a benchmark from one net asset value (NAV) calculation to the next, before fees and expenses. Daily gains or losses in leveraged and inverse funds can affect their net assets and level of exposure to their benchmarks. For this reason, portfolio managers may buy or sell underlying investments in the funds at the end of each trading day to realign the funds’ target levels of exposure to their benchmarks.
The impact of accumulated gains or losses on investments over time, known as compounding, is magnified in leveraged and inverse funds, especially those funds with larger multiples or exposure to volatile benchmarks. Compounding can enhance returns during trending periods (gains are more than or losses are less than a fund’s stated multiple times its benchmark’s returns), but it can hurt returns in volatile periods (gains are less than or losses are more than a fund’s stated multiple times its benchmark’s returns). Investors using leveraged and inverse funds over periods longer than a day are encouraged to actively monitor their investments, as frequently as daily.
Let’s look at how compounding could have impacted a hypothetical 3x daily objective Nasdaq-100 fund in two different market environments. (Please note, this does not account for fees or financing or transaction costs.) In 2017, the Nasdaq-100 returned 33.0% in an upward-trending, low-volatility environment. In this type of environment, compounding clearly enhanced returns, as the hypothetical 3x daily objective Nasdaq-100 fund returned 127.7%.
Source: Bloomberg, 12/31/16 – 12/31/17. The performance quoted represents past performance and does not guarantee future results. Investment comparisons are for illustrative purposes only and not meant to be all-inclusive. Index performance does not reflect any management fees, transaction costs, taxes or expenses. Indexes are unmanaged and one cannot invest directly in any index.
However, heading into 2018, volatility increased and the market experienced a fairly sharp correction from late January to mid-February, followed by a quick V-shaped recovery. Overall, the Nasdaq-100 returned 3.2% in Q1 2018. In this higher-volatility, range-bound market, compounding hurt returns for the hypothetical 3x daily objective Nasdaq-100 fund, which returned just 5.2%.
Source: Bloomberg, 12/31/17 – 3/31/18. The performance quoted represents past performance and does not guarantee future results. Investment comparisons are for illustrative purposes only and not meant to be all-inclusive. Index performance does not reflect any management fees, transaction costs, taxes or expenses. Indexes are unmanaged and one cannot invest directly in any index.
Leveraged and inverse Nasdaq-100 funds are investment tools with a range of applications. They can be used to express directional views on the market, to over/under weight this particular market segment or to help hedge an existing position.
While there are still reasons to be optimistic about markets and the economy, there is no shortage of risk. With this bull market showing signs of aging, hedging with inverse funds may be an attractive alternative to selling equities and potentially incurring capital gains taxes. However, investors should have a comprehensive understanding of the features, advantages, disadvantages and risks associated with leveraged and inverse ETFs before investing, including any fund-specific risks outlined in their prospectuses.
Leks Gerlak has been an Investment Strategist with ProShares since 2015. His responsibilities include portfolio analysis, education, product research and development, and the presentation of investment strategies using the company’s leveraged and inverse (tactical) ETFs. This information is not meant to be investment advice.
Investing involves risk, including the possible loss of principal. Most leveraged and inverse funds seek returns that are a multiple of (e.g., 2x or -2x) the return of a benchmark (target) for a single day, as measured from one NAV calculation to the next. Due to the compounding of daily returns, leveraged and inverse fund returns over periods other than one day will likely differ in amount and possibly direction from the target return for the same period. These effects may be more pronounced in funds with larger or inverse multiples and in funds with volatile benchmarks. Investors should monitor their holdings as frequently as daily. Most leveraged and inverse funds are non-diversified and each entails certain risks, which may include risk associated with the use of derivatives (swap agreements, futures contracts and similar instruments), imperfect benchmark correlation, leverage and market price variance, all of which can increase volatility and decrease performance. Inverse funds should lose money when their benchmarks or indexes rise. Please see their summary and full prospectuses for a more complete description of risks.
Carefully consider the investment objectives, risks, charges and expenses of ProShares before investing. This and other information can be found in their summary and full prospectuses. Read them carefully before investing. There is no guarantee any ProShares ETF will achieve its investment objective. Shares of any ETF are generally bought and sold at market price (not NAV) and are not individually redeemed from the fund. Brokerage commissions will reduce returns. ProShares are distributed by SEI Investments Distribution Co., which is not affiliated with the funds' advisor or sponsor.