The “Flight to Crap” Returns

One of the most popular articles in today’s Wall Street Journal is entitled “The Riskiest Bets in the Stock Market Are the Most Popular.”   The article notes that TQQQ, the ProShares UltraPro QQQ, has become the most actively traded ETP[i].    SPY, the SPDR S&P 500 ETF, is in second place, with UVXY, the ProShares Ultra VIX Short-Term Futures ETF and SQQQ, the ProShares UltraPro Short QQQ, in fourth.  Trailing in fifth is QQQ, the Invesco QQQ Trust, the ETF upon which TQQQ and SQQQ are based.  Traders are returning to a risk mentality and strategies that worked well for many during the post-pandemic run-up, seemingly without regard to – or even in spite of – the changing monetary and financial environment.

It is hard to imagine a more favorable environment for embracing risk than when the Federal Reserve and other central banks were aggressively supplying monetary stimulus alongside period bouts of fiscal stimulus.  Market declines were swiftly met with waves of fresh money, emboldening traders to buy dips.  We have seen many new entrants into the investment markets who experienced great investing success.  But changing economic environments require different investing strategies.  While we are currently seeing a successful return to a 2020-21 risk mentality, it is crucial to recognize the limitations of that mindset and the limitations of some of the favored products for expressing that mindset.

If money is free and real rates on safe assets are negative, it is far easier to speculate on companies that lack current profitability in favor of future potential growth.   Yet we had begun to see investors punishing even profitable growth-oriented companies whose growth rates have suffered, only to now see investors bargain hunting among highly speculative favorites.   For one thing, meme stocks have returned to the forefront.

We have previously referred to the periods when investors seek highly speculative stocks to be a “flight to crap”.  The term is a play on “flight to quality”, when investors seek stocks with stable earnings and bonds with higher credit ratings.  Instead, we defined a flight to crap as:

… when we see money piling into stocks or sectors strictly because they are going up, because speculative traders see the possibility of profit by jumping on a trend.  This is momentum investment on steroids, when speculators see a trend and the only thing that matters to them is price movement.  Fundamental valuations matter little, if at all.

As with all investment strategies, there is a time and place when they work best.  I seriously question whether a period of high inflation and Fed rate hikes is that time.

That said, kudos to the folks at ProShares, who have created ETFs that have clearly captured the public’s fancy.  But their popularity is an indication of just how risk-tolerant investors have become, particularly when their speculation is centered in products that have a significant inherent flaw.  That flaw is discussed in bold letters in the ProShares prospectus.  Leveraged ETFs like TQQQ, SQQQ and UVXY are designed to match the leveraged return on their benchmarks over a single day, and tend to lag those benchmarks over time.  This is how ProShares explains it (bold is theirs):

The return of the Fund for periods longer than a single day will be the result of its return for each day compounded over the period. The Fund’s returns for periods longer than a single day will very likely differ in amount, and possibly even direction, from the Fund’s stated multiple (3x) times the return of the Index for the same period. For periods longer than a single day, the Fund will lose money if the Index’s performance is flat, and it is possible that the Fund will lose money even if the level of the Index rises.

They remind us of this just two paragraphs later:

The Fund does not seek to achieve its stated investment objective over a period of time greater than a single day.

The high trading volume in leveraged ETFs can be interpreted in a positive way.  It could indicate that traders are reluctant to go home long a decaying asset and strictly using leveraged ETF’s as trading vehicles.  But we know that people are going home long nonetheless, which can be an expensive proposition.

The sustained underperformance of leveraged ETFs stems from the fact that they hold derivatives that either decay, or need to be rolled, or both.  The costs of decay and/or rolling derivatives cause the ETFs to systematically underperform their benchmarks as a result.   Options trading on leveraged ETFs is a particularly wild case, since you’re effectively trading options on options.  I would much rather see traders who want leveraged exposure to QQQ to use individual options because investors can control their risk, reward, and decay much more effectively than by utilizing products with embedded derivatives that are outside the trader’s purview.   

Our newest investors know nothing but an era where greater risk brought uniformly greater reward, and even veteran investors have little experience with inflationary periods or sustained rate hikes.  On one hand, it is encouraging to see that traders are taking advantage of products that can be used to hedge losses besides simply using those that allow them to speculate on further gains.  But it seems to be an inopportune time to utilize risk-enhancing products, especially those that warn of inherent underperformance.

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[i] ETP = “exchange traded products,” a catch-all term that includes ETFs (exchange traded funds) and ETNs (exchange traded notes).