In this turbulent market, traders are often looking for the best way to capitalize on each swing.  With the market giving us 200 point ranges on a near daily basis, it seems there is ample opportunity to book some great profits.  And thanks to the ingenuity of Wall Street (only halfway serious there) you can now get even more bang for your buck with leveraged funds.

Leveraged Funds – What Are They and How Do They Work?

Leveraged funds are ETF’s (Exchange Traded Funds) that trade just like stocks.  You can buy or sell at any time during the day, and most of these funds have plenty of liquidity to make trading relatively efficient.  These funds are based on an underlying index and aim to give traders daily returns that are double the returns you would get if you invested directly in the index.

So for instance if you own the Proshares Ultra S&P 500 (SSO), and the S&P were to rise 2%, your position should be up roughly 4%.  There are leveraged funds available for large indices like the Dow, Russell, and S&P as well as for individual sectors such as healthcare, financials, and oil & gas.

An interesting additional resource is the inverse leveraged fund.  An inverse fund actually returns the opposite of the index it represents.  So if you owned the Proshares Ultrashort S&P 500 (SDS), and the S&P were to fall 2%, your position should be up roughly 4%.  These ultrashort positions have become very popular as hedging vehicles, especially in IRA’s where short positions are typically not allowed.

In what may be considered “taking a good thing too far,” we have actually seen a few 300% leveraged funds introduced in the past few months.  In this case, $100 buys you $300 worth of exposure either up or down.  While the tool can certainly be used for good, there are some important issues you must consider when using leveraged funds.

Unexpected Consequences – Drawbacks for Leveraged Funds

Aside from the obvious ability to lose money twice as fast if you are wrong, there are a few other significant problems with leveraged funds.  The issues arise with the mathematics of compounding returns.  Leveraged funds are set up to mimic the returns of an index and double the return (or inverse return) on a daily basis.  But this can make them quite inefficient on a long-term basis.

Consider for instance the index returns for a theoretical week:

• Monday: Down 5%
• Tuesday: Up 3%
• Wednesday: Down 4%
• Thursday: Up 6%
• Friday: Down 2%

Using the returns for the index, you would end up with a 2.42% loss for the week.  So if you were using a leveraged fund you would expect your losses to be 4.84% and an inverse fund might be expected to gain 4.84%.  But as I’ll show you, the math doesn’t quite work that way.  Consider the returns for a $100 invested in a leveraged fund:

• Monday: Down 10% – Now holding $90
• Tuesday: Up 6% – Now holding $95.40 (90 times 1.06)
• Wednesday: Down 8% – Now holding $87.77
• Thursday: Up 12% – Now holding $98.30
• Friday: Down 4% – Now holding $94.37

So you can see that with the compound interest kicking in for both losses and gains, the losses turn out to be 5.63% (significantly larger than simply double the index losses for the week).  When you consider this scenario playing out over the course of a month or a year, you can begin to see how inefficient the fund can be for long-term performance.But lets look at the inverse fund.  Would it actually outperform since its counterpart underperformed during this particular week?  Here is the math on an inverse leveraged fund for the same period:

• Monday: Up 10% – Now holding $110
• Tuesday: Down 6% – Now holding $103.40
• Wednesday: Up 8% – Now holding $111.67
• Thursday: Down 12% – Now holding $98.27
• Friday: Up 4% – Now holding $102.20

You can see that using an inverse double return fund actually returned 2.2% which is significantly less than you would expect.  The index declined 2.42% for the week.  You might expect the leveraged inverse fund to gain 4.84% but instead you only received 2.2%.  Again, the compound math gets in the way when you have large swings back and forth.

The current market has plenty of gyrations back and forth which makes both leveraged and inverse leveraged funds inefficient as long-term strategies.  The funds make for excellent tools in protecting your portfolio on a daily basis.  In fact, the ZachStocks Growth Model has booked solid gains in these positions offsetting losses in growth stock names.  They can also net you some very attractive absolute returns in a short time if you predict the market’s direction correctly.

But the bottom line is to avoid using these funds as long-term positions.  They were not designed to hedge a portfolio through a bear market, and will not be effective in doubling your returns for a long-term uptrend.  As always, know what you are invested in, and study the details carefully.

Special “hat-tip” to Adam Warner at Daily Options Report who mixes fun and pop culture with a healthy dose of market wisdom.

FD: No positions in stocks or funds mentioned

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