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September 10, 2007 11:24 pm

Risk and reward of exposure

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Did you have a hunch that the month of August wasn’t going to bode well for the Dow? Were you an early believer in dotcom mania, but foresaw the bursting of the bubble before anyone else? If you have gut feelings about the market, leveraged index funds may be the investment for you.

With leveraged index funds – long and short funds that seek to match a multiple of stock market performance – investors are finding ways to make bets based on their instincts. These funds are designed to provide extra exposure to particular indices with less investment through derivatives such as futures, swaps and options.

“Most high net worth, sophisticated investors and advisers have a strong sentiment, or a strong opinion, about which way the market is going to go,” says Ron Fernandes, chief executive of Direxion Funds. “These funds – by applying a consistent fashion of leverage, either a long or a bear – give them the opportunity to concentrate that opinion. It’s about bringing a point of view to the table.”

The three biggest providers of leveraged index funds include: ProFunds of Bethesda, Maryland, Rydex Investments of Rockville, Maryland, and Boston-based Direxion Funds. Direxion, which began offering leveraged funds in 1997, now has 34 funds, including the Nasdaq 100 Bull 2.5x Fund; the Latin America 2x Fund; and the Emerging Markets Bear 2x Fund. Profunds, which also has an extensive line of leveraged exchange-traded funds, offers funds such as the Ultra Small Cap, which doubles the returns of the Russell 2000; and the Ultra Mid Cap, which doubles the returns of the S&P 400. Rydex offers 16 mutual funds that employ leverage, including the Dow 2x Strategy, the Europe 1.25x Strategy Fund, and the Inverse Mid-Cap Strategy Fund.

“The market goes up, but it also goes down,” says Michael Sapir, founder and chief executive of ProFunds. “This gives people the ability to either hedge part of their portfolio or try to make the most of a down market.”

The appetite for leveraged funds – which are typically benchmarked daily to published indices – has grown as investors have become savvier over the years, according to Jim King, director of portfolio management at Rydex funds, which launched the first explicitly leveraged index fund in 1993.

“When we first rolled them out, they were used for directional speculation, now there is a new breed of shareholders that are using inverse funds as a hedging tool – particularly if they have a long-term holding in an equity,” he says. “People are using leveraged funds to maintain exposure to equities and free up cash to do other things, like invest in other non-correlated asset classes.”

These funds are targeted at sophisticated individual investors and financial advisers, as well as institutional investors, such as pension funds, endowments, and the proprietary trading desks at big broker dealers.

Mr King says they are for the “do-it-yourselfers” of the investment world – those investors who have specific objectives in mind. However, he says: “Even though the concept of magnifying returns is straightforward, some of the mechanisms behind it are quite sophisticated”.

Take, for instance, a hypothetical fund designed to produce returns that correspond to 150 per cent of the Nasdaq. On the first day of trading, let’s say the Nasdaq rises from 100 to 106, producing a 6 per cent gain and an expectation that the fund will rise by 9 per cent (6 per cent x 1.5 per cent). On the same day, the fund’s net asset value (NAV) increases from $10.00 to $10.90 for a gain of 9 per cent.

But on day two, let’s say the index drops from 106 to 99 for a loss of about 6.6 per cent. The fund, naturally, falls 9.9 per cent to a price of $9.82. On each day, the fund performed in line with its benchmark, but for the two-day period, was down 1.8 per cent, while the index lost only 1 per cent.

Russ Kinnel, a director at Morningstar, the investment research provider, says leveraged funds can be dangerous because they don’t behave “the way you’d expect”.

“You figure that with a leveraged index fund, you’re going to get 1.5 times or two times the S&P 500 returns. Sure it’ll be more volatile, but if the market is up 10 per cent over the long term, then you should be up 20 per cent. But because of the way leverage works, it doesn’t turn out that way,” he says. “They are probably more than just gimmicks, but not much more.”

Mr Kinnel points to a study done in 1998 by a professor at the University of Chicago business school that found that when returns of leveraged funds were compounded over 30 years, they didn’t add up to gains of 1.25 times to two times more than their benchmark index. Many of these leveraged funds even lagged the market for a long period.

Mr Sapir, at ProFunds, says he “disputes the conclusions”.

“Our funds that are levered on the long side and the short side are designed to produce the multiple of [a given index’s] returns on a daily basis. But because of compounding, it can be more or less [than the index’s returns] over the long term,” he says. “Compounding can work for you, and it can work against you.”

To mitigate some of those risks, Mr King at Rydex says investors ought to rebalance their portfolio more often than they might ordinarily. “During the technology run of the late 90s, those tech positions and equity positions became pretty heavily weighted and a lot of people got hurt,” he says, adding that “there’s no rule of thumb” for how often the rebalancing ought to occur, just that investors should do it “more frequently”.

Of course, leveraged funds aren’t always about making positive bets on the market. Inverse funds, often called “bear funds” or “short funds,” are designed to provide results that move in the opposite direction of the daily price movement of a given index. These funds give you the ability to hedge a portfolio or make the best of a down market, as well as help manage risk and volatility.

Inverse funds may also complement an existing portfolio, says Mr Fernandes. “We see some clients using our short funds to hedge out other parts of their portfolio. It’s not always about octane, sometimes it’s about tempering,” he says. “It’s one of the reasons our funds are often seen in lists of best performers and worst performers. If the bull fund is doing well, the bear fund doesn’t. But if it were a bear market, it would be just the opposite.”

Generally speaking, leveraged funds are short- to intermediate-term investments. “Where you’d see them in a long-term investment is in partial leverage,” says Mr Fernandes. “It’s almost always to accomplish a larger objective.”

Typically these funds require hefty minimum investments – for instance ProFunds has a $15,000 minimum. And, of course, there are the fees: these funds tend to charge annual fees of anywhere between 1.2 per cent and 2.45 per cent – a pretty penny considering they’re index funds.

“One of the normal benefits of index funds is that they’re low-cost, but these funds charge more,” says Mr Kinnel. “It’s partly because they’re smaller, but also because they are largely tailored to advisers who want to do some type of market timing for their clients, and market timers don’t care as much about racking up costs.” Leveraged index funds “take an index fund – which is a nice, dependable, boring investment – and make it a stressful, unreliable one”, according to Mr Kinnel. “There’s something great about how steady a low-cost index fund can be. The leverage can be your enemy.”

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