Money Stuff: Triple ETFs Triple Your Fun

This is just a neat trick of arithmetic:

The Europe-listed $11 million GraniteShares 3x Long MicroStrategy Daily ETP (LMI3) is the ultimate example. While MicroStrategy itself is higher by more than 100% this year, LMI3 has dropped nearly 82% — despite offering leveraged long exposure to the stock. That dynamic holds on a one-, three- and six-month basis as well.

LMI3 is an exchange-traded product that offers investors three times the daily return of MicroStrategy Inc.’s stock. If MicroStrategy goes up 3% on Monday, LMI3 goes up 9%. If MicroStrategy goes down 5% on Tuesday, LMI goes down 15%. If MicroStrategy goes up 110% over the first eight months of 2024, LMI3 goes down 82%. It’s wild! 

That’s from Money Stuff podcast co-host Katie Greifeld’s article “One-Day-Only ETFs Are Jack Bogle’s Nightmare Brought to Life,” about leveraged single-stock exchange-traded funds. The point of these funds is to give investors two or three times a stock’s daily returns, and they come with grim health warnings telling you not to hold them for the long term: LMI3 does a good job of giving you three times the daily return of MicroStrategy, but a horrific job of giving you three times the year-to-date return of MicroStrategy. (It gives approximately negative 0.8 times the year-to-date return.) “The funds offer amped-up exposure only to a stock’s one-day return,” writes Greifeld, “given that the daily rebalance of the options book erodes returns over time.”

The intuition is this. A 3x leveraged ETF is designed to give you three times the daily return of a stock, whenever you buy it. So on Monday morning, say, the ETF price is $100 and the stock price is $100. The ETF gives you exposure to the return of three shares of stock. The stock goes up 10% that day, so the ETF goes up 30%, so that at the end of the day the stock is at $110 and the ETF is at $130. On Tuesday, you buy a share of the ETF. You pay $130, and if the stock goes up 10% again, you want your money to go up 30%. So the ETF now has to give you exposure to more than three shares of stock: It has to give you exposure to three times $130 worth of stock, or about 3.55 shares. [1]  And then if the stock goes up 10% again, the stock will end the day at $121 (up 10% from $110) and the ETF will end the day at $169 (up 30% from $130). [2]  

To get this result, the ETF has to buy more shares at the end of the day on Monday: It started Monday with each ETF share representing three shares of the underlying stock, but it needs to start Tuesday with each ETF share representing 3.55 shares of the underlying stock. So at the end of Monday it needs to buy 0.55 more shares, to continue to offer three times the return of the underlying stock. [3]

But what if, instead, the stock goes down 9% on Tuesday? Then:

• The stock closes at $100.10, down 9% ($9.90) from $110.
• The ETF closes at $94.90, down 27% ($35.10) from $130. [4]

So the two-day return of the stock is +0.1%: up 10% Monday, down 9% Tuesday, so from $100 to $110 to $100.10. The two-day return of the ETF is -5.1%: up 30% on Monday, down 27% on Tuesday, so from $100 to $130 to $94.90. The ETF gives you three times the Monday return, and three times the Tuesday return, but negative 50 times the Monday-and-Tuesday return.

Your intuition here could be roughly: “Every time the stock goes up X% and then down Y%, the ETF goes up 3X%, and then down 3Y% of a bigger number, so the loss is greater. And every time the stock goes down Y% and then up X%, the ETF goes down 3Y%, and then up 3X% of a smaller number, so the gain is smaller.” Or your intuition could be “the ETF is forced to buy shares every time they go up and sell shares every time they go down, which has to be a drag on returns.” Either way, these intuitions work only if the stock is volatile: If the stock goes steadily up (or down), 3x the daily return will end up getting you roughly 3x the long-term return. But if the stock bounces around a lot, tripling the daily returns can get you much worse than 3x — even worse than 0x — the long-term return.

MicroStrategy, needless to say, is very volatile — it moves on average about 7% per day — so this more or less happened. [5] If a stock goes up 8% one day, down 7% the next, then up 8%, down 7%, up 8%, etc., then in the long run it will go up a lot. If it goes up 24% one day, down 21% the next, then up 24%, down 21%, up 24%, etc., then in the long run it will go down a lot. [6] If the daily returns are mostly positive but very volatile, and you triple them, the long-term returns can be negative.

Anyway the good news is that (1) these products are fun and (2) people seem to understand that they are not buy-and-hold products. Greifeld:

Advocates say these ETFs are meeting a demand in the investment world among a community of highly engaged retail traders. US-listed single-stock funds now command about $13.4 billion after the first set sail two years ago, according to Bloomberg Intelligence data. ...

Napkin math suggests that traders are following instructions. For example, the $1.5 billion Direxion Daily TSLA Bull 2X Shares fund (TSLL) has an average trading volume of nearly $303 million. Dividing that sum by the fund’s average market capitalization of about $1.1 billion produces a turnover rate of 28.2%, meaning it takes about 3.5 days to completely flip its portfolio. That compares to about 185 days for the $503 billion Vanguard S&P 500 ETF (VOO), which is popular among buy-and-hold investors.

But if your thought process was “I like MicroStrategy, I like 3x MicroStrategy even more, so I’m going to buy and hold the 3x fund,” there’s a good chance you got your face ripped off.

Incidentally. You could imagine an alternative structure:

1. You put $100 into the ETF on Jan. 2.
2. It borrows some money and buys $300 worth of the stock.
3. On Dec. 31, it sells the stock, pays back the borrowing, and gives you three times the return on the stock for that year.

That is, it’s not hard to build a fund that does give you three times the annual return on the stock. The problem with that fund is: What if you want to buy it on Feb. 1? If the stock is already up 10%, the fund is up 30%, and buying it in February will no longer give you 3x exposure. (If the stock goes up another 10%, for a total of +21%, the fund will close the year up 63%, giving you a mere 25% return on your money, not the 30% you wanted. [7] )

The good and bad thing about exchange-traded funds is that they trade every day. There are some strategies for which that doesn’t matter. An index fund — “we will give you 100% of the return on the S&P 500” — is easy to implement as an ETF: You just buy all the stocks in the index, and if new investors come in, you buy a bit more of those stocks. 

Other strategies are harder. We have talked a couple of times about buffer ETFs, whose basic proposition is “we will give you 100% of the return on the S&P 500, but floored at 0% and capped at 10%” or whatever. These products, though, require buying longer-term options, and they can’t generally rebalance every day. If that buffer fund launches on Monday when the S&P is at 5,500, and you buy it on Tuesday when the S&P is at 5,800, you don’t get the downside protection from 5,800 (you get it from 5,500). “The S&P 500 return, but it can’t go down” is the rough pitch for the product when it launches, but that pitch decays over time.

Leveraged daily-return ETFs, on the other hand, do rebalance every day, so they do offer the same proposition — “three times the return on the stock” — whenever you buy them. But that comes at a cost.

One model for a hedge-fund trade is that there is some robust, predictable, not-quite-economically-rational demand for a thing, and you get into the business of providing it. The index rebalance trade is the classic example: Some new stocks get added to the index, on the rebalance date index funds need to buy those stocks at whatever their current price is, so big multistrategy hedge funds employ teams (or “pods”) whose job is to buy those stocks ahead of the rebalance date and sell them to the index funds. If you can identify price-insensitive flows, or irrational investor behavior, and be on the other side of it, you can make money.

Last month I joked that “there are not so many astrology pods” at big multistrategy hedge funds, but of course this logic suggests that there could be. The idea is something like:

1. People irrationally sell all their stocks when Mercury is in retrograde. 
2. You have a calendar and can anticipate when Mercury will be in retrograde.
3. You sell stocks just before that happens and buy them back a week later, profiting from the irrational drop caused by Mercury in retrograde.

“Astrology is a subset of mass psychology,” I wrote, “and so is investing, so, you know, there’s gotta be something there.” I’m not sure there’s much, though. I just made up this story about Mercury in retrograde, and I doubt it’s true. The number of astrologically influenced traders is probably small enough that you can’t make any money trading against them in large-cap US stocks.

Still, something to think about, maybe a pattern to be aware of. Here’s a new paper titled “Animal spirits: Superstitious behavior by mutual fund managers,” by Shenglan Chen, Jing Li, P. Raghavendra Rau and Cheng Yan:

Using a unique dataset from China spanning 2005 to 2023, we investigate how superstitious beliefs influence mutual fund managers' risk-taking behavior and how this influence evolves over their careers. We find a significant 6.82% reduction in risk-taking during managers' zodiac years, traditionally considered unlucky in Chinese culture. This effect is particularly pronounced among less experienced managers, those without financial education backgrounds, and those with lower management skills. The impact also intensifies during periods of high market volatility. Our findings challenge the traditional dichotomy between retail and professional investors, showing that even professional fund managers can be influenced by irrational beliefs early in their careers. However, the diminishing effect of superstition with experience and expertise suggests a gradual transition towards more rational decision-making. Our results provide insights into the process by which financial professionals evolve from exhibiting behavior akin to retail investors to becoming the rational actors often assumed in financial theory. 

I don’t quite know how you’d trade against that, but “fund managers adjust their asset allocation strategies” and “significantly underweight risky stocks during their zodiac year,” so I suppose if a lot of fund managers had the same zodiac year you’d want to dump risky stocks just before that year, etc. “The diminishing effect of superstition with experience and expertise suggests a gradual transition towards more rational decision-making,” but there’s always some irrationality somewhere, and somebody looking to exploit it.

One way to interpret worries about artificial intelligence is that they are mostly boasting. [8]  After all, a lot of the people who worry about artificial intelligence killing or enslaving humanity are also the people who are working on artificial intelligence. So when Sam Altman, the chief executive officer of OpenAI, goes around publicly worrying that AI might kill us all, what he is really saying is “I am building a technology that is unimaginably powerful and will transform every aspect of human life, so it sure must be worth a lot of money.” If he just said that, you might be skeptical; it is obviously in his self-interest to talk about how powerful his technology is. But instead he goes around worrying about it, which makes him seem more credible: It is not obviously in his self-interest to talk about how dangerous his technology is and how carefully he needs to be checked. It’s more subtly in his self-interest to do that.

You could take a similar view of OpenAI’s “capped-profit” model. If OpenAI just went around saying “we’re going to be a $10 trillion company,” you’d be like “yeah, sure, every founder has a pretty grandiose view of their company, this number means nothing.” But instead OpenAI goes around fretting about its investors who might lose out if their valuation is capped at $10 trillion, so you think “hmm this is something they’re really worried about.” The Financial Times reports:

OpenAI is in discussions about changing its corporate structure to become more investor-friendly, as it pushes ahead with a multibillion-dollar fundraise and seeks to retain its lead over Google and other rivals.

The artificial intelligence start-up has spoken to investors about restructuring itself, according to three people involved in those conversations. Although a final form has not been agreed, it would likely be more attractive to financial backers by seeking to simplify the company’s current complex non-profit structure, they added.

The discussions come as OpenAI is in talks to raise new capital at a valuation of more than $100bn, according to multiple people familiar with the deal, in a fundraising round that is expected to be led by venture capital firm Thrive Capital. Apple and Nvidia are in talks to participate in the round for the first time alongside existing OpenAI partner Microsoft, according to two of the people. ...

Shifting to a simpler for-profit structure would be welcomed by the start-up’s financial partners, according to one investor in OpenAI. “All preferred investors have a profit cap, there’s a lot of talk about making it a more traditional investment so we’re not capped on our upside,” the person said.

“Returns for our first round of investors are capped at 100x their investment,” said OpenAI in 2019, when it raised a billion dollars. I guess I am kidding about the $10 trillion — the caps are individually negotiated, and perhaps the people coming in at a $100 billion valuation would expect a lower cap — but perhaps not. “We’re so sorry,” Sam Altman tells them sadly, “but because of our unique corporate structure, once we hit a $10 trillion valuation we just can’t give you any more upside. I know that’s a huge problem, though, so we’re looking to see if there’s any flexibility to fix it.” OpenAI has found a way to make “we expect to be a $10 trillion company” sound bad, which somehow makes it sound credible.

I’m kidding, probably; the real point of the restructuring would presumably be to get rid of OpenAI’s nonprofit governance structure, in which ultimate decisions about OpenAI are made by a nonprofit board of directors who don’t have any fiduciary duties to the investors, and who might actually believe the AI-doom stuff and pull the plug on a profitable business. You can’t have that.

Sometimes, over the past few years, Elon Musk has pumped up the price of Dogecoin. Dogecoin is a meme crypto token, Musk appears to find it funny, and he’ll sometimes joke on Twitter or X or Saturday Night Live about Dogecoin. Because Dogecoin is a meme token, and Musk is a famous rich online person, his jokes about it generally make it go up. Later, it often goes down again.

This annoys people, for some combination of good and bad reasons. The good reason to be annoyed by this is that it is annoying: It’s just sort of immature and stupid, and doesn’t Musk have better and worse things to do with his time? The bad reasons to be annoyed by this is that you think it’s a pump-and-dump. “Elon Musk is fraudulently pumping up the price of Dogecoin for his own nefarious purposes,” you think, “and people who buy Dogecoin when he tweets about it are deceived and will lose money.” No! For one thing, it seems pretty unlikely that Musk has ever profited from pumping Dogecoin [9] : It’s not like he bought a bunch of Dogecoin and then sells them after tweeting about it. What he is getting out of his Dogecoin stuff is mostly entertainment, not Dogecoin trading profits.

For another thing, it’s not like Musk ever lied about Dogecoin in his public statements. Or, rather, he did, but he was clearly kidding: 

On July 17, 2020, Musk tweeted a meme of a photo of a dust storm overtaking an urban area, with the face of the Dogecoin Shiba Inu superimposed on the dust cloud. The cloud was labeled “dogecoin standard.” The urban area about to be overtaken was labelled, “global financial system.” Above this image, Musk superimposed the remark, “It’s inevitable.” 

You could read that to mean “in order to pump up the price of Dogecoin, Musk falsely asserted that the global financial system will move to the Dogecoin standard,” but you’d have to be kind of an idiot. It was a joke! You can tell because it featured a picture of a meme Shiba Inu! That’s how Dogecoin works! It’s all a joke.

That quote is from a lawsuit that people did file against Musk, accusing him of running a pump-and dump on Dogecoin. I wrote about it last year, and was skeptical that anyone could have been deceived:

Dogecoin is an online joke, and Elon Musk is a famous person who likes online jokes, and for a time there was a valuable synergy there. The value of Dogecoin as an online joke went up when Elon Musk was making Dogecoin jokes online. If you bought Dogecoin because Elon Musk tweeted about it, you didn’t buy it because you expected it to become the global monetary standard, or because you expected Tesla to start pricing cars in Dogecoin or whatever. You bought it because Elon Musk tweeted about it. That was the whole analysis: “Elon Musk tweeted about this joke dog coin, so I’m gonna buy it.” He really did tweet about it! How could you have been misled?

The lawsuit was dismissed last week. From the judge’s order dismissing the case:

Plaintiffs allege false and misleading statements. ... These paragraphs allege statements by Musk on “Twitter” to the effect that Dogecoin might be his favorite currency and that he had purchased some for his son, that Dogecoin is the people's crypto and the future currency of Earth, that Dogecoin might become the standard for the global financial system and the currency of the internet, that Musk agreed to become Dogecoin's CEO, and that Musk might put a “literal” Dogecoin in SpaceX and fly it to the moon and that Dogecoin would pay for the mission, that Tesla vehicles could be bought with Dogecoin, and the like. These statements are aspirational and puffery, not factual and susceptible to being falsified. They cannot be the basis of 10b-5 lawsuit … and no reasonable investor could rely upon them.

Obviously no reasonable investor has come anywhere near any of this, and the securities laws are built around reasonable investors, not whatever this is.

One thing that you could do is:

1. Print out some fake checks with a fake name.
2. Make out one of the checks to yourself, for $20,000.
3. Go to an ATM and deposit the check in your bank account.
4. Take the $20,000 out of your bank account in cash.
5. Whee!

There are two very large problems with this plan: 

1. It is illegal! This is check fraud! Writing a fake check to yourself and stealing the money from the bank! Come on.
2. It might not work? In modern banking, if you deposit a $20,000 check in an ATM, the bank might not let you take out the money for a couple of days, until the check clears and the money comes in. Here, the money won’t come in — the check is fake — so you’ll never get the money out.

Point 1 is always true, but Point 2 is, you know, roughly true. Your bank might let you take the money out immediately (if it thinks you’re a good credit risk), or it might let you take some of the money out immediately (figuring that’s a manageable risk). Or I suppose it might let you take all of the money out by accident? The New York Post reports:

A new TikTok trend has people posting their attempts to exploit a “glitch” in Chase bank ATMs that offers “infinite free money” — but quickly learning that a bank and its money are not so easily parted.

Experts say the “glitch” videos look an awful lot like check fraud — one of the oldest scams in the book.

Videos urging customers at the bank to take advantage of the “glitch” quickly took off online, prompting people to deposit fake checks for large sums of money. The glitch would credit some of the sham deposits to the customers’ accounts before the checks cleared. …

But, Chase quickly fixed the bug, and is now clawing back any money doled out to people who didn’t deserve it.

The people who took advantage of the glitch were soon reporting that their accounts were locked and hit with massive negative balances.

Nothing here is legal advice, but also, nothing on TikTok is legal advice, come on. “TikTok told me how to get infinite free money,” oh great, come on. “Now I’d better post it to TikTok too,” come on!

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