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Mutual Funds

Winners on Steroids

Leverage is great in a bull market. But watch out when things turn sour.

Look at the fund rankings in the April issue of Kiplinger's Personal Financeand you'll see one each from Rydex and Direxion and two from ProFunds. All are index funds, which seek to track market benchmarks. But these four are index funds with pop -- they employ leverage. The ProFunds and Rydex Dow funds aim to double the gains of the Dow industrials on a daily basis. ProFund Utilities UltraSector seeks 1.5 times the daily returns of a utility index, and Direxion Developed Markets Bull 2x aims for twice the daily gains of a foreign-stock index.

But leverage is a two-edged sword. Consider Rydex Dynamic SP, which seeks to double the results of the SP 500 each day. In 2001, its first full year, the fund's H shares lost 34%; in 2002, they tumbled 47%. By contrast, the SP lost 12% in 2001 and 22% in 2002. The older ProFund UltraOTC, which seeks to return twice the daily performance of the Nasdaq 100 index, lost an astonishing 99% during the 2000-02 bear market.

ProFunds, Direxion and Rydex funds are sure to make winners' lists in bear markets, too, because they offer leveraged funds that gain when stock prices fall. Over the past year, those funds have been at the bottom of the rankings.

The lessons are clear: Before investing, make sure you understand how a fund works. And beware of leveraged funds. What's hot now can burn you later.