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These Funds Can Be Hazardous to Your Wealth

Leveraged and inverse mutual funds and exchange-traded funds don't produce the returns most investors anticipate. Instead, they deliver huge losses -- or puny gains.

By Steven Goldberg, Contributing Columnist, Kiplinger.com

April 14, 2009

Real estate investment trusts have performed hideously over the past year. 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 problem is that leveraged and inverse ETFs and funds don't deliver the performance most investors expect -- except over a single day. Beyond that, they tend to return much less than you'd expect and often lose gobs of money -- regardless of the direction of the underlying index.

Right in the prospectus, ProFunds -- as well as Direxion, PowerShares and Rydex, the other big purveyors of these products -- tell you that they strive to meet their goal over a period of precisely one day. Largely because of the quirks of arithmetic, doubling an index performance over a day is much different from doubling an index performance over a year -- or even a month or a week. Tripling an index, or returning three times the opposite of an index, does even stranger things.

The home page of Direxion ETFs is the clearest of the four providers. "Daily Investment Goals. Not Monthly Investment Goals. Not Annual Investment Goals," the Web site declares of its triple-leveraged ETFs.

But even Andy O'Rourke, marketing director of Direxion funds, acknowledges that many people miss the message. "Unknowing investors who are used to mutual funds look at the quarter-end performance, and very often our funds are at the top. What people don't notice is that they're also at the bottom." Direxion ETFs, he says, are designed to be short-term trading vehicles. "If you're holding them for more than a day, you're out of sync with the investment."

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.

The numbers work like this. Imagine you buy an index that falls 10% the first day, then gains 20% the next day. You start with $100. After the first day, you have $90. After the second day, you have $108.

Now imagine you have a fund that gives you double that index return on a daily basis. Based on the above scenario, you might expect to have $116 after two days. But that's not how the math works. Instead, on the first day, you lose 20%, leaving you with $80. On the second day, your investment jumps 40%, to $112.

The other problem is that to maintain their leverage, these funds do exactly the opposite of what a prudent investor would do. They buy more of an index after it rises in price, and sell more after it falls. That cripples performance over time.

Investor interest surges

Because the bear market burned so many investors on buy-and-hold investing, these products are mushrooming in popularity. You can now invest in leveraged and inverse ETFs that dabble in currencies and commodities, as well as in stocks and bonds. According to Morningstar, there are now 108 such ETFs with assets totaling roughly $25.5 billion -- this despite a Morningstar article that warns of their dangers.

The longer you invest in a leveraged fund the more likely you are to lose money, warns Morningstar analyst Paul Justice. With these investments, time doesn't heal; it destroys. "It's an absolute fool's game," he says. "Unfortunately, there's a great swath of investors and even some financial advisers who think they can time the market with these funds. They're touted on CNBC all the time."

As the volatility of an index increases, the tendency of these funds to lose money grows exponentially. "Precisely when volatility goes up is when these funds perform the worst," Justice says. Yet it is the most volatile indexes -- financials, for instance, over the past year -- that attract the greatest investor interest.

Professors William J. Trainor Jr. and Edward A. Baryla of East Tennessee State University echo Justice. "Most investors should be wary of this investment vehicle," they wrote in the Journal of Financial Planning. "Extreme swings in value are inherent in this type of fund."

Even though leveraged funds do a lousy job of doubling (or tripling) your return over periods longer than a day, they do a terrific job of increasing your volatility by double or triple that of the index over longer periods. So these funds deliver less return-and more risk.

Another example helps to illustrate their danger. Suppose you were savvy enough to anticipate that financial stocks would tank over most of the past 12 months. Through April 13, Morningstar's Financial Services index lost 50% of its value. Someone foolish enough to invest in ProFunds UltraSector Financials, which aims to double the return of a financial-stock index, would have gotten relatively close to what they'd bargained for: a 73% loss.

But an investor who bet on UltraShort Financials ProShares would have lost money, too -- to the tune of 48%. With these funds, it's often a case of heads you lose; tails you lose.

Steven T. Goldberg (bio) is an investment adviser.

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