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Is Leverage Really The Edge

It is phenomenal to know how many different types of financial products exist. The more I read, the better I get. Some concepts are easy, less risky to follow as individual investors while some are complicated and come with higher risks. 

Putting my individual investor hat, I feel if you spend a little bit of time, then index funds can be your friends and you may become your own fund manager. I highly recommend looking at the Vanguard funds and starting your journey there. I will do a separate blog on how I started my investment journey and will discuss all my anxiety and excitement. This path of low cost investment is really awesome. Invest early and invest often is the key to success. This is the number one advice I would give to start with in the field of investments.

There are a number of complicated products like options, futures, swaps which are also known Derivatives in finance. In simple terms these are complex financial products that allow you to hedge some of your risks example futures which is an agreement between two people for the purchase and transfer of an asset at an agreed price and on a future date. The risky piece is that you might think that the price of company X might go down 6 months in the future, but you can never be absolutely sure.

There are some type of people who are good at this (lets call them financial gurus) but I personally try to stay away from such complicated products for the most part of my investments. To clarify, it is still really interesting and exciting to learn about how these products work, but to spend the time to actively monitor and day trade is unfortunately a challenge for me because of my other responsibilities. 

I still allocate some of my money in a research account, the whole portfolio of which is comprised of complex financial products that I am interested in learning about. (Disclaimer - Using leveraged products is very risky and I do not recommend investing into it without having professional advice). One such product I started looking at is Leveraged Exchange Traded Funds (ETF). The exciting part about this is leveraged ETFs can "potentially" provide 2x or 3x returns from the market. The big word is "potential" as there are large risks at play here. Some examples are leveraged ETFs that track 2x or 3x times the S&P 500 or Nasdaq 100. So if an index goes 1 point up, the leveraged ETF rises to 2 points. Its all about hedging risks, if you feel the market is going to go up, its a good bet. But at the same time, it can go down, causing you to lose twice or thrice the amount of money. Hence I am always extremely cautious while working with these.

The SEC has put together a pretty detailed article on these risks highlighting it is not for the daily investors. To call out these risks again -

  • The ETF may not actually go up the exact number of 2x or 3x the index, this could vary significantly.
  • There are higher fees involved as compared to your normal index ETF.
  • There is daily re-balancing that happens which will lower down your returns and on a flat day could even give you negative returns.
  • When the market goes down 1x, your portfolio may go down 3x or may be more.

I mainly wrote this article because I started looking at this last year and the strategy did well when the market was up. Down in the picture below I have compared UPRO vs SPY. UPRO is a 3x leveraged ETF for the S&P 500 index whereas SPY tracks the S&P 500 index itself.

UPRO vs SPY
Source: Google Finance (Comparison of UPRO to SPY)



Now the graph above looks fascinating with the returns as I said when the times were good, but here is a picture of the other side of the story. I compare TQQQ vs QQQ when times were not so good. Remeber, TQQQ is a leveraged vs QQQ is the normal Nasdaq 100 index.
TQQQ vs QQQ
Source: Google Finance (Comparison of TQQQ to QQQ)

This is depressing as the Nasdaq index is still down for the last 1 month and hence the leveraged ETF is down 3x. Not for the faint of heart! I am still going to stay invested for some time and keep watching as the Nasdaq improves in the next couple of months.

Its definitely something exciting to learn as you all know I am always looking to diversify and find new ways to grow my money but I am proceeding with caution and only using a small portfolio which I can afford to lose.

(Disclosure: I do invest and own UPRO, TQQQ, QQQ, SPY and Vanguard Funds. I am not receiving any compensation from Vanguard itself for writing this blog. Please review the Disclaimer section prior to any investments.)