Reasons to Run From Leveraged Funds

The strategy behind these funds on steroids may surprise you.

By SHARE

Let's say you think the S&P is bound to go up--way up--in the coming months. Why not double down with a leveraged fund that gives you double the return of the S&P? Or on the other hand, if you're convinced that a sector is going to fall hard, why not bet against it with a fund that returns three times the opposite of that sector's index?

It's not as simple as it sounds. Kiplinger columnist and investment adviser Steven Goldberg (a former colleague of mine) explains the arithmetic behind these funds and why they often return a lot less than you'd expect. The most important thing to know is that they only deliver the performance of a single day, not of a year or even a month. That fact makes a huge difference. Consider his example:

The Vanguard REIT Index fund tumbled 50% through April 7. Now, suppose you were smart enough to buy a fund that goes in the opposite direction of the Vanguard fund, namely ProFunds Short Real Estate fund. Its objective is to return the inverse of a REIT index. Your gain: Not 50%. Not even 25%. Instead, you lost 11%.

The story delves into the specifics of the strategy and includes several other examples that illustrate the hazards of investing in leveraged and inverse funds. Goldberg's conclusion: "Like cigarettes, these funds tell you on the package exactly what they do. And just as surely as cigarettes can cut years off your life, these funds can reduce your wealth substantially. You're better off at the craps tables."

Leveraged and inverse strategies are popping up in ETF form as well. Here's a look at one of the newer offerings, which seeks to triple the return of a given index.

For a quick primer on exchange-traded funds, see 10 Things You Didn't Know About ETFs.