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The Short Answer

Look Before Leaping Into Leveraged Funds

Supercharged returns can lead to rapid-fire losses.

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Note: This article has been corrected to fix an arithmetic error in the section titled "Compounding Your Losses." Click here for more information.

Question: I've never bought a leveraged fund before, but I feel pretty confident that a bear market is coming and am thinking of buying a leveraged bear-market ETF. Is there anything I should know? 

Answer: Whatever your expectations for the market's future performance, leveraged funds are not to be entered into lightly. Sometimes referred to as funds on steroids, leveraged funds amp up the risk/reward proposition as compared with conventional nonleveraged funds and offer the potential for much bigger gains, though they can lead to much bigger losses as well.

Leveraged funds come in both traditional mutual fund and ETF forms, though more often the latter. A typical leveraged fund uses derivatives to double or triple the daily performance of a given stock, bond, or commodity index or to match the inverse (opposite) of its performance at one of those multiples. (Their names often include terms such as "2x," "3x," or "leveraged.") So, for example, a two-times S&P 500 leveraged fund is designed to double the daily performance of the S&P 500 index (before fees are taken out). If the index gains 1% on a given day, the two-times leveraged fund should gain 2% that day, and if the index loses 1% the leveraged fund should lose 2%. However, because of compounding, this pattern may only hold true for one day before becoming distorted--sometimes badly.

Compounding Your Losses
As an example, let's say you invest $1,000 in the two-times S&P 500 fund mentioned earlier. On the first day, the index loses 1%, so your leveraged fund loses 2%. You now have an asset worth $980, whereas if you'd invested in the index itself, you'd have one worth $990. (For the purpose of this example, we'll leave out the impact of fees on performance.) On day two, the index gains 2%, and your leveraged fund gains 4%. So, your asset that had been worth $980 gains $39.20 (980 times 0.04). Had you invested in the index directly, your $990 would have gained $19.80 (990 times 0.02). By now, your original investment in the leveraged fund is worth $1,019.20, whereas an investment directly in the index would be worth $1,009.80. Sounds good, right? But on the third day, the index again loses 2%, leaving you with $978.43 in your leveraged fund, while an investment in the index would be worth $989.60. Thus, the three-day return on your original $1,000 investment in the leveraged fund is negative 2.16%, while the return on the index itself is negative 1.04%. As you can see, the leveraged fund's losses can pile up quickly, which is why they are best suited for those who plan to own them for only a very short time, such as day traders.

High Fees Don't Help
Another important factor to consider is the cost of owning a leveraged fund. Don't let the fact that many of them are index-based fool you--they can be quite expensive. The average leveraged mutual fund charges an expense ratio of around 2%, while the average leveraged ETF charges just under 1%. That's a strong headwind for a leveraged fund to overcome and one that will only add to your woes if the fund you choose experiences losses. (It should be noted that here and elsewhere throughout this article we are talking specifically about funds identified
as leveraged funds within the alternative Morningstar Category. Funds from other categories that also use leverage--such as those in the leveraged net long category, in which leverage is used to achieve greater than 100% exposure to certain securities while using offsetting short positions to achieve a net long exposure of 100%--are not included in this discussion and issues raised here may not apply to them. For more on the distinction between leveraged net long and pure leveraged funds, see this recent Short Answer.) 

Fasten Your Seat Belt
Even if you are willing to accept the risk of heavy losses that comes with leveraged funds, one thing you can bank on is a bumpy ride. Leveraged funds, by their very nature, are more volatile than conventional funds investing in similar core holdings. Take a fund like  ProShares Ultra S&P500 (SSO), which seeks to double the daily performance of the S&P 500. For the three-year period ended March 31, its standard deviation (a measure of the degree to which a fund's performance varies over time) was double as well, at 19.32 to the index's 9.59. True, an investor with the stomach to hold on to the fund over that entire time period would have enjoyed annual returns of nearly 31% to the index's 16.1%. But for most investors, that level of volatility is awfully hard to ride out over long periods, especially when the overall market seems so much more stable by comparison.

Of course, the biggest problem with using leveraged funds is the risk of losses--not just small losses, but major, painful losses. Your original question had to do with a leveraged bear-market ETF, which is designed to match the inverse performance of the S&P 500 and, thus, increase in value if the benchmark index falls. Of course, if you time your purchase right, you will make some money. But what if you're wrong? You could lose a lot in a hurry.

A case in point: Coming out of 2013, a year in which the bull market delivered a 32% return (including dividends) for the S&P 500, some market watchers predicted that a correction (10% drop) or even a bear market (20% drop) was likely in 2014. Instead, the bull market marched on, with the index tacking on another 13.7%. Of course, you wouldn't have known that at the start of the year, and if you'd bought a bear-market fund such as  ProShares UltraPro Short S&P500 (SPXU), which is designed to triple the inverse daily performance of the index, and held it for all of 2014, you would have lost 36.9% of your investment.

For investors with an insatiable appetite for risk, perhaps using leveraged funds to place the occasional very-short-term bet on the market's direction makes some sense. For the rest of us who feel that our recommended daily allowance of market risk is satisfied by using conventional mutual funds and ETFs, there's really no need to go there.

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