Sometimes I imagine finance company corporate boardrooms dreaming up new products. They probably refer to it as innovation or something like that. But innovation in finance really only goes one of two ways:*
- This product/strategy/platform will bring value to our customers. If we build it and execute well, we can generate considerable profits by delivering value to the marketplace.
- This product/strategy/platform is horrifyingly bad, but people want to buy it even as it will enrich us at the expense of our customers. Let’s get it to market as quickly as possible.
Exchange traded funds (ETFs) have gained popularity over the past decade. ETFs are the next step in the evolution of the mutual fund – a similar vehicle with added tax and trading advantages. One other trait ETFs share with their mutual fund cousins is they are boring. Diversified pools of capital. Tracking indices. You will also pay very little to purchase such a product – less than 0.1%. But our attention spans are better suited to 40 minutes than forty years, and you can’t make much money in 40 minutes buying an S&P 500 ETF.
But you could buy a 3x levered single stock ETF. That is, an ETF that is meant to return 3x the daily return of a particular stock. Shockingly, the only stocks issuers have created 3x levered ETFs for are those frequently bought and sold by retail investors.** One stock beloved by retail is MicroStrategy (ticker MSTR), a business intelligence company whose founder decided to use the company treasury to stockpile Bitcoin a few years ago. MicroStrategy presently has a market capitalization of about $25 billion and owns Bitcoin presently valued at about $12.5 billion.[i] So it is less accurate to say MicroStrategy is a business intelligence company and more accurate to say it is a one-half business intelligence company and one-half bitcoin repository. Anyway, the stock has functionally become a Bitcoin derivative, as “investors” use it to speculate on the price of Bitcoin.
The thinking of an enterprising ETF issuer goes something like “retail investors like speculating on the price of Bitcoin, so they like speculating on the price of MSTR stock. I bet they’ll love 3x levered MSTR stock!” Why buy MSTR when you can leverage your position 300% with a simple ETF? The 3x levered MicroStrategy ETF arrived on February 2, 2022. Since then, here are the returns of MicroStrategy stock (MSTR) and the ETF providing 3x the daily returns of MSTR stock:[ii]
MSTR: +314.6%
3X Leverage MSTR ETF: -99.79%
Yes, that is a negative sign before the return number for the levered ETF. A $10,000 investment in MicroStrategy stock the day the 3x levered ETF hit the market is now worth $41,460.[iii] The same investment in the 3x levered ETF is presently worth…
$21.
I try to avoid issuing blanket recommendations, but if you rode the 3x levered MSTR ETF down from $10,000 to $21 I suggest you cash out and enjoy two bowls from Chipotle. You will need to rustle up additional funds to afford the guacamole.
What happened?
We (humans) are very bad at thinking in percentages. A brief exercise:
If an investment loses fifty percent, what percent must it then gain to return to its original value?
Most people’s gut answer is 50%. The answer is 100%.
Here’s how it works. Say your investment is worth $100. If it loses 50%, it is now worth $50. From there, a 50% gain will only get you back to $75 – still 25% beneath its original value. A 100% gain from $50 returns you to $100. The math is simple but counterintuitive.
Now, let’s purchase your investment using 3x leverage. You invest $33 and borrow $67 to buy an investment for $100. It loses 50% and is now worth $50, but you still owe $67. The tricky part about leverage is if your collateral is suddenly worth less than what you owe, your counterparty will liquidate you immediately – a margin call. So in this case you get liquidated and still owe your counterparty $17. Thanks for playing. Buying securities on margin (margin = borrowed funds; that is, leverage) requires a mind-numbing amount of paperwork. It is difficult to get approved for a margin account without understanding the risks. You have to keep signing your name after every conceivable way your counterparty can think of to phrase you may lose more than your original investment.
An important disclosure all 3x levered ETF products make (and many “investors” ignore) is they are meant to return 3x the daily returns of the underlying asset. They are not meant to be held longer than a trading day. Remember the math exercise we reviewed earlier. Say the underlying asset is worth $100 on day one. That day it returns +5% for a closing price of $105. The following day it performs -20% for a closing price of $84. The following day it stages a furious rally of +19% to get back to $100. A 0% return over three days.
Now add 3x leverage. Day one’s 5% returns become 15% for a closing price of $115. Day two’s -20% becomes -60% to close at $46. Day three’s furious rally returns +57% to end at $72.22. Hold the underlying asset for three days and you have a return of 0%. Hold a 3x-levered ETF on the underlying asset and your three-day return is -27.78%. That is why these levered products are meant for short-term (less than one trading day) speculation, not to be bought and held. Since it takes a larger percentage gain to recover a given percentage loss, volatility destroys levered investors. The 3x levered MSTR ETF is pretty good at delivering 3x the daily return of MicroStrategy stock, and it is also pretty good at wiping out the equity of a long-term holder. Which is exactly what one should expect given the high level of volatility in MicroStrategy stock.
In this case, this product allowed investors to swap the risk of a margin call with the risk of a 99+% loss while the underlying asset triples in value. Levered ETFs also provide an avenue for investors (read: speculators) to utilize leverage without all the annoying paperwork and disclosures and signatures.
Levered ETFs are gaining popularity. 2x-levered Nvidia (NVDA) ETFs and 3x-levered QQQ (popular ETF tracking the NASAQ 100) have received massive inflows since NVDA and QQQ began their massive runup in 2023. Of course, the levered NVDA ETF was brought to market after Nvidia began its run in ’23. Remember option (2) from the financial innovation paradigm (horrifyingly bad, but people want to buy it so let’s get it to market…) Luckily for levered Nvidia investors, the 2x levered Nvidia ETF has returned +258% to NVDA’s +134% this year.[iv] Leverage works well when undisturbed by downward volatility. But it ultimately cuts both ways, and during downturns it can magnify losses to unrecoverable levels. I suspect there is more than one investor marveling at the returns of his 2x-levered NVDA ETF while blissfully unaware of the risks.
Utilizing leverage without the risk of losing more than your principal investment sounds nice, which probably in part explains the popularity of levered-ETFs. But it should throw up some red flags. You’re not so much reducing risk as you are swapping one (losing more than your principal) for another (getting zeroed while the underlying asset triples). There are two rules of leverage every investor must remember:
- Leverage is a double-edged sword. It can magnify losses as it can magnify gains.
- Losses require even greater returns to recover, so magnified losses can quickly become unrecoverable.
Or, if one rule is easier to remember:
If it sounds too good to be true, it probably is.
Sean Cawley, CFP®
*This is kind of a joke.
**Not shocking.
Neither asset allocation nor diversification guarantee against investment loss. All investments and investment strategies involve risk, including loss of principal.
Content here is for illustrative and educational purposes only. It is not legal, tax, or individualized financial advice; nor is it a recommendation to buy, sell, or hold any specific security, or engage in any specific trading strategy. Results will vary. Past performance is no indication of future results or success. Market conditions change continuously.
This commentary reflects the personal opinions, viewpoints, and analyses of Resolute Wealth Management. It does not necessarily represent those of RFG Advisory, clients, or employees. This commentary should be regarded as a description of advisory services provided by Resolute Wealth Management or RFG Advisory, or performance returns of any client. The views reflected in the commentary are subject to change at any time without notice.
[i]https://www.microstrategy.com/press/microstrategy-announces-first-quarter-2024-financial-results-now-holds-214-400-btc_04-29-2024
[ii]https://graniteshares.com/institutional/uk/en-uk/etps/graniteshares-3x-leveraged-microstrategy-etp/
[iii] YCharts, Fundamental Charts, Growth of $10,000, MSTR, 02/02/2022 – 09/19/2024.
[iv] YCharts,