The ProShares UltraPro QQQ ETF Turned $10,000 Into $1.6 Million. Could This Other ETF Be Next? | The Motley Fool (2024)

One of the most popular ETFs among investors is ProShares UltraPro QQQ ETF (TQQQ 3.41%), a fund that uses leverage to generate triple the daily returns of the Nasdaq 100 index. And it's easy to see why so many people are paying attention to it: In less than 15 years in existence, it has delivered total returns of more than 16,000%. If you had invested $10,000 in the ETF at the time of its 2010 inception, and reinvested any distributions along the way, you'd be sitting on more than $1.6 million today.

In a nutshell, the fund benefited from an exceptional 14-year stretch for big technology stocks. Aside from the relatively tame 2022 bear market and a short-lived plunge when the COVID-19 pandemic started, the Nasdaq essentially has gone straight up for years. It has been an excellent time to be invested in the index, with leverage.

While I don't necessarily think this (or any) ETF will replicate this level of performance over the next 14 years, there are good reasons to believe that small cap stocks are primed for years of outperformance. And there's a similar ETF that might seem interesting to watch.

It could be time for small caps

Small cap stocks have underperformed the S&P 500 for over a decade, as mega-cap technology stocks have disproportionately fueled the stock market's performance. In fact, the average stock in the Russell 2000 small cap index trades for a price-to-book valuation that is less than half that of the average S&P 500 component.

With the Federal Reserve set to cut rates for the first time since 2020, it could create a positive environment for small caps. For example, small caps tend to be faster-growing businesses, and often use more leverage (debt) than their large cap counterparts, so falling rates can create a favorable cost of capital.

There's a leveraged ETF for that...

There's an ETF called the Direxion Daily Small Cap Bull 3X Shares (TNA 1.58%), which aims to deliver three times the daily performance of the Russell 2000 index, which is widely considered to be the most comprehensive index of U.S. small cap stocks.

It is similar in structure to the ProShares UltraPro QQQ ETF. It has 3x daily leverage, has a similar expense ratio, and tracks the most widely used benchmark index for its target stock type. However, the results have been very different.

The math isn't your friend with leveraged ETF investing

The biggest problem with leveraged ETF investing is that because they aim to produce three times the daily return of an index, the math doesn't favor long-term investors.

Consider this simplified example. Let's say that during a market crash, the Russell 2000 loses 10% in one day, 10% the following day, and another 10% on the third day. A $1,000 investment in a standard Russell 2000 ETF could be expected to decline to about $729 after this sequence of events. You would then need a 37% rebound to get back to the original $1,000.

On the other hand, a 3X leveraged Russell 2000 ETF would decline 30% each day. After the three-day crash, your $1,000 investment would be worth just $343. You would now need the ETF to rise by 192% just to get back to even.

Of course, this is an extreme and hypothetical example, but the math causes leveraged ETFs to generally underperform over time (the leveraged Nasdaq ETF is a rare exception).

A look at the real-world numbers tells the story. Over the past 10 years, the Russell 2000 has produced a 7% annualized total return. You might expect that the Direxion Daily Small Cap Bull 3X Shares might have delivered somewhere in the neighborhood of 21% total returns, but you'd be very wrong. The annualized total return of the leveraged ETF over the past decade is negative-0.6%.

Should you invest?

It's important to keep in mind that leveraged ETF investing is a highly speculative practice, and it can go very wrong, very quickly. If the Russell 2000 goes the wrong way, it would magnify your losses dramatically. Investors who simply want a set-it-and-forget it way to add small cap exposure to their portfolio would be better off with a basic (unleveraged) ETF like the Vanguard Russell 2000 ETF (VTWO 0.58%).

If you believe small-cap stocks are in a good position to outperform in the years to come, there's nothing wrong with making a small speculative investment in a leveraged ETF if you're aware that's what you're doing -- speculating. But just be aware that leveraged ETFs can be quite volatile, and it isn't unheard of for investors to lose most, or even all of their money if things go poorly.