Most investors know that betting with borrowed money raises the stakes — you win big or lose big. This year winning is in, and some investors have earned more than 40 percent with leveraged funds tied to the broad market.
But leveraging has long been seen as only for sophisticated investors and short-term speculators who can afford the losses. People saving for college or retirement have been told to play it safe with long-term holdings. And most small investors don’t even bother with individual stocks and bonds; they use mutual funds and exchange-traded funds managed by pros.
But fund providers, constantly looking for new ways to attract investors, have hit on leveraging in the past decade or so. A growing number of funds using leverage offer returns two or three times as large as those of the underlying index of securities.
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“The techniques used in these ETFs could generally help smaller investors that don’t want to trade options, futures, or to trade on margin to have a leveraged position,” says As’Ad Gourani, CEO of AG Wealth Management in Ann Arbor, Michigan. But that doesn’t mean small investors should flock to these products, he adds.
“In a sense, it is safer than buying derivatives, yet it remains a short-term trading vehicle, which is not recommended strategy [for small investors], rather than a suitable long-term investment,” he says. “Because, simply, compounding works both ways, on the upside and downside.”
“Leveraged ETFs sound good on paper, but don’t work in the real world,” says ReKeithen Miller, portfolio manager with Palisades Hudson Financial Group in Atlanta. “For example, bear market funds, which promise to offer positive returns when the market declines, are only good for people who plan to hold the funds for [just] days at a time. They are not suitable investments for the long-term due to how returns are calculated and compounded. In the quest to offer investors more control, fund providers have made things even more complex.”
While the concept behind leveraged products seems simple, the execution is not. In theory, borrowing funds allows an investor to increase the securities under his or her control. If you start with $100,000 and borrow another $200,000, a 10 percent gain will earn you 30 percent on your original stake, less interest and fees related to the loan.
In practice, most leveraged funds don’t do it this way, however. Instead, they buy and sell options and futures contracts, which allow the fund to control a large block of securities for a small down payment. The contracts gain or lose value as market conditions change, amplifying the fund’s results.
Of course, as the first example showed, a 10 percent decline for an investor leveraged three to one can turn into a 30 percent loss, made even worse by the borrowing costs. That also happens to a fund using derivatives such as options or futures.
Investors are therefore more likely to buy leveraged funds if they think the market is heading up, though some inverse funds using leverage are designed to profit when the market falls, by shorting, selling put options or futures contracts that will rise when the linked securities lose value.
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Investors can also use options, futures or short sales to make money when their ETFs lose value, just as they can with common stocks.
One of the big players in this market is ProShares, the big ETF provider. It offers a range of funds leveraged two and three times against indexes for U.S. and foreign stocks and bonds, as well as currencies and commodities. Its ProShares UltraPro S&P 500 (ticker: UPRO), for instance, provides three times the gains of the Standard & Poor’s 500 index, and is up more than 42 percent this year. This ETF has an expense ratio of 0.75 percent or $75 per $10,000 invested.
But most experts agree leveraged funds are not for ordinary folk.
Leo Kelly, CEO of Verdence Financial Advisors in Hunt Valley, Maryland, says that high risks and fees make leveraged products suitable only for short-term traders.
“Traders who want to get more bang for their buck can obviously, with the addition of significant risk, enhance their returns if the trade is successful,” he says. “This is not an investor’s product. The risk and carry costs are not acceptable.”
Those costs translate into expense ratios that are high compared to those of ordinary ETFs. The ProShares fund charges are more than the SPDR S&P 500 ETF, an unleveraged S&P 500 index ETF ( SPY), which has an expense ratio of 0.06 percent. Big expenses won’t bother an investor who has tripled his or her gains in an up year, but would be salt in the wound in a downturn.
Even ProShares notes that its funds are not for everyone. It points out that they need daily monitoring, as the combination of leverage and compounding can make performance very different from that of the underlying index. The intricacies of resetting the leveraging after each day’s market move can add to the damage, experts say.
Put simply, leveraging makes it very hard for a fund to recover from a big drop.
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“There are no magic beans,” Kelly says. “Higher returns come with higher risk.”
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Leverage Stakes Too High for Most Investors originally appeared on usnews.com
