Investors are increasingly using Leveraged funds, both ETFs and Mutual Funds. Such funds can definitely provide enhanced returns to a properly constructed portfolio if the investor understands the risks involved and is using these funds in a specific investment strategy.
Leveraged ETFs and Mutual Funds
Most of the attention in recent years has been on the leveraged ETFs. What seems to get lost in discussions is that the concept of leverage has been around for a long time. Mutual Funds involving leverage and shorting of index strategies have been in existence for the past 15 years. There are now more than 100 mutual funds that use index leveraging. The leveraged ETFs have become more popular because they can be traded like stocks very quickly and offer the excitement of quick profits.
Leveraging an Index
Leveraged funds strive to achieve multiple returns of the index that is being tracked. They do this by using derivative investments involving futures and options contracts on the underlying index. Some funds provide 2X leverage and others provide 3X leverage. It would be expected that if the underlying index rises 5%, a 3X leveraged fund would rise 15%.
There is not an exact relationship over time between the returns of the index used compared to the leveraged fund. This relationship breaks down for periods greater than a few days due to how derivative investments perform. So, if the index rose 5%, a 3X leveraged fund may provide 10% or 20% return depending upon the structure of the fund. A lot has been written on this point with the usual advice to avoid the funds as long term investments.
Does this point really matter? If the market rises 20%, does a leveraged investor really care if his portfolio rises 50% or 70%? The movement is still a huge amount. The answer is YES, it does matter if the leveraged fund tracks the index correctly if the investor is using these funds in a correct strategy.
Using Leveraged Funds in Investment Strategies
Normally, investors should not be using funds that involve leverage. Using leverage is just gambling in most portfolios. The thrill of watching a fund increase dramatically over a short period can really get the adrenaline going. However, the chance of a leveraged loss can be devastating. Investors in these funds can lose much of their assets just as easily. So for average investors, just stay away from these funds and go to Atlantic City once in a while to have some fun.
There are uses for using leveraged funds as short term instruments in a diversified portfolio. The investor may have particular knowledge of one investment sector and be confident that a very short term rise is imminent. Buying into a leveraged fund can take advantage of this knowledge. However, such an investor should also protect this investment by buying some offsetting Options, such as Puts, in case his belief is wrong. In this instance, the investor needs to know how the leveraged fund will act compared to the index so that he properly constructs his offsetting investment. If the investor holds the leveraged fund for more than a few days, the performance ratio of the leveraged fund vs. the underlying index can fall apart and would cause his offsetting investment to over or under perform. Essentially, this investor would have no confidence in how both investments would perform relative to one another.
Some experienced investors will use leveraged funds, without offsetting investments, for only a few hours. This might seem like gambling, and it is. But these investors are experienced traders who understand the intra-day movements of a particular niche of the market and can handle the volatility of these funds.
Average Investors Should Stay Away
An investor should not use leveraged funds routinely. They should definitely not use them if they cannot afford to experience a large loss in the fund. Inexperienced investors should stick with large well diversified mutual funds for their investments over the long term. Short term gambling has no place for investors, especially when the investments will be used to fund future retirement.