Why Leveraged Funds Are Bad Bets

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.

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 obvious over longer periods: Over the five years ended July 20, 2009, the S&P 500 has posted an annualized 1% loss, while the fund has lost an annualized 12%.

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 42% (despite gaining 36% thus far in 2009), and has posted a positive return only once in a full 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.

Rydex Dynamic NASDAQ-100 2X Strategy  (RYVYX)
Here's a roller-coaster ride. As its name states, the fund provides double the return of the tech-heavy NASDAQ 100. It's lost more than 65% three times already (2001, 2002, and 2008). It's posted a stunning 103% gain since the market's most recent trough on March 9, 2009. But does anyone feel lucky enough to jump on board now? Or to invest in its opposite, Rydex Dynamic Inverse NASDAQ-100 2X Strategy  (RYVNX)? (That fund has lost 57% in the rally.)

A version of this article appeared in the June issue of Morningstar FundInvestor.