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Why Leveraged Funds Are Bad Bets

Three times leverage does not equal three times the return.

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The equity markets have been remarkably volatile over the past couple of years, with steep plunges followed by sharp reversals (although the latter haven't been nearly enough to make up for the losses). At times like these, investors, growing frustrated with the declines in their account balances, start to find the idea of timing the market's moves especially appealing. And there are a number of mutual funds out there designed to appeal to those people; many of them are part of the ProFunds and Rydex fund families.

ProFunds and Rydex funds offer a number of funds that track different segments of the market. Some simply track indexes or sell them short; others do the same, but with an added dose of leverage that can vary considerably from 1.25 times the return to triple the return. These types of funds can provide spectacular gains over short periods to those who time their purchases just right--but they can also deliver brutal losses. Their extreme volatility can push investors out of a fund just before it mounts a huge rally.

That's just one of the issues with leveraged funds. Another is that they're designed to provide that leveraged return each day rather than over the long term. The same holds true for leveraged ETFs as my colleagues have warned about. Investors who hold leveraged funds for an extended period often won't get twice the return (or twice the inverse) of an index over that span; they typically fall short. That's because the funds lose a lot of ground on down days--negatively compounding a return always has a more pronounced impact than positive compounding. If you invest $100 each in a straight index fund and another fund that provides double the return and they both gain 10% the first day, you wind up with $110 and $120, respectively. But if the index loses 10% the next day, your balance in the first fund drops to $99, while your balance in the leveraged fund declines to $96.

Greg Carlson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.