"Leveraged" mutual funds, once pitched as the can't-lose investment deals of the decade, may eventually wind up looking more like the bombs of the 1990s.
In the past 12 months, leveraged funds -- quasi-index funds that buy futures and options for leverage, or an extra kick -- have proliferated. Part of their surge springs from an eye-catching marketing message: Funds such as Rydex Nova, Potomac OTC Plus and ProFunds UltraBull are sold on the premise that their leveraged position will help them achieve returns 1.25 times to two times more than their benchmark index each day.So far, the funds appear to be beating the market. According to Lipper Analytical Services, Rydex Nova, one of the older leveraged funds, has produced a return so far this year of 24 percent compared with the Standard & Poor's 500-stock index's 21.58 percent with dividends reinvested. ProFunds UltraOTC, which tracks the Nasdaq Composite Index, has done even better with a 109.81 percent return compared with Nasdaq's gain of 24.15 percent.
But will these results hold true over the long run?
No way, says a new study from Nicholas Polson, a professor at the University of Chicago business school, and Ph.D. candidate Jeffrey Yasumoto. Following a seven-month investigation, the two conclude that when returns of leveraged funds are compounded over 30-plus years, they don't add up to gains of 1.25 times to two times more than their benchmark index. Indeed, leveraged funds will generally lag behind the market for a long period. The funds may even lose money when the market is up.
"Over 30 years, you can underperform the index 1/8if you're in a leveraged fund 3/8," declares Mr. Polson.
The idea for the study was sparked by Mr. Polson's neighbor, who earlier this year told the professor he had placed some retirement money into leveraged funds. His curiosity piqued, Mr. Polson decided to calculate the effectiveness of these funds. He developed a mathematical framework for understanding the compounded long-run returns of leveraged funds.
Mr. Polson then calculated the returns of two hypothetical funds -- one that was leveraged to produce returns 1.5 times the S&P 500 each day, and one that was leveraged to two times the Nasdaq. He then compiled the daily closes of the S&P 500 back to 1965 and the daily closes of the Nasdaq back to 1982. Finally, he plotted the results of the two hypothetical leveraged funds against the returns of their benchmark indexes.
The results surprised him. Mr. Polson found that the only time between 1965 and the present when investors in leveraged funds might have outperformed the market was during the recent bull market. Leveraged funds otherwise lagged behind from 1966 to 1995. Indeed, only in bear markets did the 1.5-leveraged fund behave as expected -- that is, it dropped 1.5 times more than the S&P 500.
In bull markets, however, even where the index was up 29 percent, the leveraged fund was up just 38 percent -- not 1.5 times, to 44 percent. And sometimes a hypothetical leveraged fund lost money in a rising market. For example, between 1967 and 1972 when the market gained 10 percent, a leveraged fund would have lost 6 percent, the study says.
Mr. Polson attributes the odd performance results to an "asymmetry in returns." In a down market, leveraged funds fall faster than the market because their use of futures and options magnifies a market drop, he says. When the market rises again, leveraged funds are thus bouncing back from a lower base. If this effect is compounded over a long period, leveraged funds ultimately don't end up producing returns of 1.25 times to two times more than their benchmark index, determines Mr. Polson.
In a separate study of leveraged funds that stretches back to 1925, Mark Riepe, vice president at the Schwab Center of Research, also found that the funds can lag behind the market for a long period. After the Great Depression of the 1930s, for instance, it took an investor in a 1.5-leveraged fund until 1946 to catch up with the market.
"This asymmetry in returns is not in an investor's favor," says Mr. Polson. "There's just no free lunch -- it's still hard to beat the index."
What's an investor to do? Many investors have placed long-term retirement money into the risky funds at the urging of their financial advisers. In Seattle, for instance, financial planner Paul Merriman says that he always suggests to his clients -- even to retired folks -- that they put between 5 percent and 10 percent of their portfolio into leveraged mutual funds.
To be fair, most fund companies that offer leveraged funds don't paint the investments as buy-and-hold vehicles. Many acknowledge that leveraged funds have a tough time in a down market. Firms such as Rydex, ProFunds and Potomac permit unlimited fund exchanges and have set up leveraged short funds that investors can switch into in a choppy market, in hopes of profiting from a market decline. The companies also try to keep inexperienced investors out by setting a high investment minimum of around $25,000.
Still, many managers of leveraged funds take issue with Mr. Polson's conclusion that leveraged funds can lag behind the market and even lose money in a rising market. Michael Sapir, chairman of ProFunds, argues that the long-term trend of the stock market is upward. That means that there are generally more up days in the market than down days, which in turn suggests leveraged funds will eventually bounce back more than the market and outperform, he says.
Tom Michael, manager of Rydex Nova, argues that it is simply a matter of timing. Depending on what period is analyzed, one can make a case that leveraged funds can outperform or underperform over the long run, he says.
"One of the worst things we can do is to create expectations we couldn't meet," Mr. Michael says. "But if the long-term trend of the S&P 500 is strongly up, then we will probably outperform."