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June 2009 Mutual Fund Red Flags

Leveraged funds are bad bets.

Greg Carlson, 06/16/2009

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

Red Flags is designed to alert you to funds' hidden risks. Such risks can take many forms, including asset bloat, the departure of a solid manager, or a focus on an overhyped asset class. Not every fund featured is a sell, and in fact some are good long-term holdings. But investors should be prepared for a potentially bumpier ride in the near future.

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. 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.

That's why Rydex S&P 500 2x Strategy RYTNX gained 18% in 2004, while the S&P 500 Index gained 11%. (Granted, that's still a healthy return, but the downside can be harsh--while the S&P lost 37% in 2008, this fund lost 68%.) And in markets with pronounced ups and downs, this fund can even trail the index in a positive year. In 2007, for example, the S&P 500 rose 6%, while the fund gained only 1%. The effects are most pronounced over the long term: Over the past five years, the S&P 500 has posted an annualized 2% loss, while the fund has lost an annualized 14%.

Fees are part of the reason for those lagging returns; they're another issue with many leveraged funds (as well as other funds designed for timing market moves). Most cost upward of 1.5%--that's a high price tag for funds that are tracking indexes (with or without leverage). Some of those costs are due to the rapid movement in and out of those funds by traders. Here are a couple of other notable leveraged funds.

ProFunds Rising Rates Opportunity RRPIX
This fund provides 1.25 times the inverse return of the 30-year Treasury bond. Because long-dated Treasuries are especially sensitive to interest-rate moves, this fund's performance is extremely volatile. The fund was rolled out in late 2002, has since lost nearly half of its value, and has posted a positive return only once in a calendar year since then. In 2008, as the Federal Reserve slashed rates in response to the recession and Treasuries rallied, the fund lost 38%--a bit more than the S&P 500.

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