Other People’s Money

Archimedes said that with a big enough lever he could move the world, and the financial wizards on Wall Street have long embraced that belief.

Whether through leveraged buyouts or hedge funds, investment professionals have long relied on leverage to produce outsized gains. Individual investors are also able to deploy leverage through a variety of means–for example, by using margin in their brokerage accounts. Any time you use someone else’s money, you’re relying on leverage.

Hedge funds reported outsized gains in the last bull market, largely generated by mind-boggling amounts of leverage, and everyone wanted a piece of the alternative investment pie. But many individual investors didn’t meet the minimum asset levels required to invest in hedge funds, and many institutional investors didn’t want to take on the additional risks that hedge funds carry.

Seeing a need and sensing an opportunity, many asset managers stepped in to fill the breach, launching both traditional open-end mutual funds and exchange traded funds (ETFs) that utilize huge amounts of leverage.

Ranging from leveraged index funds that aim to double or even treble the performance of an underlying index or a specific sector to 130/30 funds that are managed  like hedge funds, investors can now utilize leverage by simply purchasing shares.

According to Morningstar data, there are now 108 such ETFs, with assets totaling roughly $25.5 billion. Investors can now make leveraged bets on everything from stocks and bonds to currencies and commodities.

But don’t be fooled. Just because these funds are packaged as traditional mutual funds or ETFs doesn’t mean they’re any safer than their more sophisticated cousins. By definition, leverage can work for you or against you.

As long-term investments, the value of these types of funds is questionable. Just as leverage can juice your returns when the markets move as expected, it can also wipe those gains out–and then some–when they move against you.

And leverage isn’t cheap. Just as you have to repay principal plus interest when you borrow money, the funds have to pay borrowing costs. That leads to average annual expense ratios in excess of 1.5 percent.

And even when things are working out as expected, performance numbers frequently don’t add up. Leveraged index funds seek to amplify the performance of their benchmarks over specific periods of time, typically on a daily basis, and they usually achieve that aim very well. But that doesn’t translate well to longer periods of time.

In fact, it’s a common occurrence for a leveraged daily index tracker to turn in a negative performance over a weekly or quarterly basis even if the underlying index is positive. The other problem is that to maintain their leverage, these funds do exactly the opposite of what a prudent investor would do: They buy more of an index after it rises in price and sell more after it falls, hobbling performance over longer periods of time. This means investors in leveraged index funds have to be cognizant of funds’ tracking periods and plan their investments accordingly.

Run more like hedge funds, 130/30 funds pose their own unique challenge for investors. Using a $100 portfolio of securities, $30 worth of stocks or bonds are borrowed and sold short, and borrowed money is used to purchase another $30 of investments. That leaves the funds with $130 worth of long positions and $30 in short positions.

As with traditional funds, management’s skill is the key to the long-term success. But unlike more standard fare, one misstep can cripple performance; the amount of leverage involved in a 130/30 fund and their fairly concentrated portfolios amplify the impact of any ill-advised decisions.

And as more investors have come to understand, if not appreciate, the effects of leverage, it seems likely that many of these funds will cease to exist in coming months and years. Over the past three months the small leveraged niche of the fund industry has been experiencing large outflows as investors simplify their portfolios.

That’s not to say these funds don’t have purpose. For traders, leveraged funds are solid ways to play short-term trends, particularly on the short side.

But for most investors these funds make little sense. Given the complexity of calculating returns over periods longer than a day, there’s a high probability of losing money, even if the index or market being tracked by a leveraged fund moves its way.

What are excellent tools for traders are not, however, particularly viable options for long-term investors.

 

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