Look Before Leaping Into Leveraged Funds

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.

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

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

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.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.