A few days ago, I saw this tweet:
I couldn’t picture in my mind what the purpose was and simply filed it away as “another meme ETF”.
Then Katie Greifeld mentioned it in her podcast with Matt Levine, Money Stuff, saying that Rob Arnott was doing the same trade and earned 12% per annum of purely uncorrelated returns.
Now you have my attention. [It is worth pointing out that I do not trust Arnott 100%, considering past controversies around one of RA’s strategies and his feud with Cliff Asness]
Still, I couldn’t say I fully understood the strategy. During the podcast, Matt noted that the trade will go wrong if the underlying goes up (or down) in a straight line. Ok, but why?
Victor Haghani and James White came to the rescue with this insight.
The key is how often you rebalance the two ETFs. If you do it daily, there is no volatility drag by definition. [They dropped this as a test in the insight that I failed miserably. Well, to be honest, I didn’t even try: found the article at 11 p.m., neurons already soaked in whatever pills’ cocktail I take to manage to get some sleep. No point in attempting to reactivate my brain]
If you do it at a low frequency and the underlying runs in a straight line, you are fucked because one leg of the trade becomes bigger than the other and you are not beta? delta? whatever neutral.
Let’s have a look at an example. I didn’t want to use MSTR because those ETFs were launched yesterday. So I picked the 3x QQQs.
Here is how I built the trade:
IRL, you do not have to run 100% CASHX. If your broker allows it, you can simply short the two ETFs against your standard portfolio.
According to ELM, what you see here is the result of how inefficiently TQQQ and SQQQ are built and run. In my daughter’s cartoon world, I’ll build this strategy and go live on a beach. Unfortunately, if you want to short this stuff, you have to pay a fee (and trading costs and slippage…but let’s stay with the shorting fees).
A quick research (from here) tells me that shorting SQQQ costs c4% lately while shorting TQQQ c1%.
Not as great, uh? Plus, there are all those other costs, so…
What if we rebalance only quarterly?
If QQQ starts a trend, the portfolio becomes largely either long or short; when the trend reverses, the strategy loses big time.
A good timeframe seems to be between a weekly and a monthly rebalance:
I played as well with the rebalancing bands but I hardly found a set that would produce a decent result. This means that the above results are just random? Probably-ish…
The volatility drag punishes the investor when the underlying has big up-and-down swings on consecutive days. If I split the horizon in two, it is easy to see that the strategy didn’t perform when the QQQ had an absurd, above 1, Sharpe. When the QQQ had a still above-average, but less abnormal Sharpe, the strategy did great.
Look at this graph, where drift = CAGR since inception. TQQQ had an absurd return since it was launched, combined with a Sharpe ratio slightly lower than QQQ. I do not think TQQQ’s past was normal and would rather bet QQQ would regress to its mean of a max 0.4 Sharpe. Which means an abysmal return for quite a long time going forward, considering the extra performance in the recent past.
If you are smarter than I, by now you are probably asking yourself “Why bother with an index? Why does he not pick a single stock, like Microstrategy, since it is more volatile by definition?”.
The Microstrategy example has a few interesting quirks. SMST, the Defiance 2x short, seems to have had a couple of great months at the end of 2024:
These top 10 hedge fund in the world results do not consider the cost to borrow those ETFs.
While these returns feel great, they still depend on the rebalancing frequency. Anything longer than a week converts into a catastrophic result. It is also quite hard to establish the cost of borrowing. And in the best scenario, you still face a 50% drawdown.
My conclusion is that earning the volatility drag is easier said than done. There is definitely nothing resembling a passive strategy. The trade looks more like finding the worst-run leveraged ETFs and shorting them, with (almost) nothing about the volatility drag.
What I am reading now:
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