The Perils of Leverage

By Russell Wild

Depressed that your portfolio has stagnated for a decade? Cheer up. If you'd bought a leveraged fund, you would have done far worse. A leveraged fund lets you double or even triple the results of an index -- or lets you wager against an index with equal vigor. You can place bets on the broad market or on narrow sectors.

Whichever way you go, bring along the Dramamine. Consider, for example, ProFunds UltraNasdaq-100 (symbol UOPIX), which aims to double the return of the Nasdaq 100 index. If you had invested $20,000 in the fund ten years ago, you would have $1,658 today (all returns are as of June 1).

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But what if you had correctly guessed in 1999 that the market would stink for ten years and plunked $20,000 into ProFunds UltraShort Nasdaq-100 (USPIX), which promises to return 200% of the inverse performance of the Nasdaq? Amazingly, you would have done even worse. Your portfolio would have been worth $1,570, a loss of 92%.

Whether you bet on or against an index, a leveraged fund will lose money over time. And it will do so in both bull and bear markets. How can this be? The explanation is that these funds promise to achieve their goals only on a daily basis. As a result, volatility and the arithmetic of reverse compounding will peck you to death, unless you can pop in and out of a fund with impeccable timing.

Here's the math: Suppose the Nasdaq 100 climbs 10% on Monday, then drops 10% on Tuesday. Even Steven? Not exactly. A $100 investment at the stock market's open on Monday in a fund that merely tracks the index jumps to $110 by the end of the day, then sinks to $99 by the end of Tuesday. You're out 1% over two days.

But look what happens with a double-leveraged fund. An investment of $100 soars to $120 on Monday, then craters to $96 by the Tuesday close. Double leverage has magnified your two-day loss from 1% to 4%. The math is even madder with triple-leveraged funds.

But if big leverage still whets your appetite, you're in luck. In recent months, Direxion has introduced 20 exchange-traded funds that promise to deliver triple the daily gains or triple the losses of various indexes. There are now 112 leveraged ETFs holding nearly $30 billion, says Morningstar. The four horsemen of leveraged funds -- Direxion, PowerShares, ProFunds/ProShares and Rydex -- are sucking in money while other sponsors, with far less dismal records, are bleeding assets.

What explains investor interest in the face of such manifest risks? The answer is surprisingly simple. "Some people are desperate to recoup their bear-market losses," says Morningstar analyst Paul Justice. Although leveraged funds are "inappropriate for 99% of all investors," says Justice, "the funds sell because of this desperation and because of abject ignorance of how the funds work."

Justice says the funds may be useful for fund managers in search of short-term hedges and really good speculators, of whom "the world has very few." For nearly everyone else: Handle with extreme care.