Thoughts on leveraged mutual funds?

[Olav23]

I was wondering if anyone had thoughts on leveraged mutual funds? Rydex offers some 150% leveraged funds (S&P500) and I'm sure there are other places as well. Possibly Profunds.

Besides for the higher expense ratio, why not just invest in a leveraged account and use the excess to invest in something else?

If you were planning on investing $1k into an S&P500, why not just invest $667 into a 1.5x leveraged fund? Then you have $333 to stick somewhere else.

Is there something wrong with my logic? I'm thinking leverage doesn't necessarily mean more risk...

Rydex Nova (Investor class) has an expense ratio of 1.11, btw, significantly more then SPY or Vanguard SP500, etc. But if you put 1% more money into it, would that make up the differential? (Or would you have to add 1% more yearly?)

 

[brewer12345]

I'm not familiar with the funds you mention, but the could do a 150% of S&P500 returns with borrowing or with derivatives. If I had to guess, I would expect the latter.

The downside to any fund that uses leverage is that they tend to have substantially higher volatility than an unleveraged fund. If you are simply investing a chunk of the $1k in the fund and putting the balance in cash equivalents, you aren't adding more rsk. However, if you put 2/3 in the Nova fund and 1/3 in, say, an EAFE index, your overall $1k is exposed to a lot more volatility than it would have been if the 2/3 were put in an unleveraged S&P500 index fund.

 

[Olav23]

Good point. But in a way aren't you basically "beating" your index? For instance, say you are trying to beat the S&P500 as your benchmark. You would have normally invested $1k in SPY, instead you invest $500 in a 2:1 leveraged S&P500 Fund (like in profunds). So, for every 1% it rose, your fund rose 2% and 5% drop, dropped 10%.

So you now have basically the same value as $1000 invested, but instead you take that other $500 and stick it in EmigrantDirect at 4% APY. Haven't you basically beaten the S&P every time (by 2% since you only put 50% of the money in emigrant, half of the 4%)?

I know they say that 80% of funds don't beat the S&P, but this seems like an easy way to do just that.

There's gotta be something wrong with my logic, so please tell me where

 

[brewer12345]

Good point. But in a way aren't you basically "beating" your index? For instance, say you are trying to beat the S&P500 as your benchmark. You would have normally invested $1k in SPY, instead you invest $500 in a 2:1 leveraged S&P500 Fund (like in profunds). So, for every 1% it rose, your fund rose 2% and 5% drop, dropped 10%.

So you now have basically the same value as $1000 invested, but instead you take that other $500 and stick it in EmigrantDirect at 4% APY. Haven't you basically beaten the S&P every time (by 2% since you only put 50% of the money in emigrant, half of the 4%)?

I know they say that 80% of funds don't beat the S&P, but this seems like an easy way to do just that.

There's gotta be something wrong with my logic, so please tell me where

Easy: you are forgetting the cost of the leverage. Either it will be explicit (the fund pays interest expense on borrowings) or implicit (baked into the cost of the derivatives). TANSTAAFL.

 

[Gone4Good]

Unlike a traditional index fund, as its primary investment strategy, the Nova Master Fund invests to a significant extent in leveraged instruments, such as futures contracts and options on securities, futures contracts, and stock indices, as well as equity securities and may enter into swap agreements. Futures and options contracts enable the Nova Master Fund to pursue its objective without investing directly in the securities included in the underlying index, or in the same proportion that those securities are represented in the underlying index. On a day-to-day basis, to collateralize these futures and options contracts, the Nova Master Fund holds U.S. Government securities or cash equivalents.

brewer wins for guessing derivatives.  The futures contracts will have an imbedded cost of cost of carry.  A fund designed to mimic 150% of the S&P 500 using derivatives should produce the same returns as one that achieves the same result by borrowing at (or close to) the risk free rate - currently around 3.75-4%. 

So in order to beat the S&P 500 using the strategy you suggested, your other investment needs to return at least 4% (and climbing with interest rates) plus an additional 1.75% in fees charged by the fund. 

So the EmigrantDirect at 4% wouldn't cut it but some other investment might.


But before we think too hard on the strategy, take a look at the returns     Nova underperformed the S&P 500 over the past 10 years   How did they manage that?  5 year performance lost almost 4x as much?



AVERAGE ANNUAL TOTAL RETURN (for periods ended December 31, 2004)
                                    PAST 1 YEAR           PAST 5 YEARS   PAST 10 YEARS
RETURN BEFORE TAXES            14.83%                  -8.52%           11.04%
S&P 500® INDEX3                   10.89%                  -2.30%           12.07%

 

[Olav23]

Wow, Yrs to go.. Good catch. I just "assumed" that the returns would be in-line with the index, as thats what the prime aim is. I quickly glanced at the Beta and saw that it was 2.0, which sounded right, against the S&P. Shoulda looked more closely at the numbers!! *when you assume...*

After that, i also looked into Profunds UltraBull (200% leverage on the S&P500)

ULPIX Index* Diff
Year To Date 0.66 2.77 -2.11
1-Month 0.95 0.81 0.14
3-Month 5.50 3.60 1.9
1-Year 18.68 12.25 6.43
3-Year 27.98 16.71 11.27
5-Year -11.39 -1.49 -9.9

I certainly see some obvious tracking error in there!!! 11.39% vs 1.49% over a 5 year period? I am hoping I'm not making some stupid compound interest math mistake, but wouldn't one expect to see 11% for ULPIX and 5.5% for Index (instead of 1.49)? Or at least CLOSE to that?

So, I guess the thing to take away is, you're right. Can't get something for free! grrr. You guys are great at shooting down my innovative ideas

 

[Gone4Good]

Some of the tracking error is undoubtedly related to the high fees. Some more will be due to the imbedded cost of leverage. This will result in magnified losses when the benchmark goes down and underperformance when the benchmark goes up - that's to be expected. But what is troubling with Nova is that they underperformed the benchmark when the benchmark went up. That sounds like a serious (mis) management problem. If you're buying a fund thinking your getting 150% of the S&P 500 index (less fees and financing) that is what you should get. It doesn't sound as if that is what these funds are delivering.