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 March 2010 When 2x ≠ 2x Two Dirty Little Secrets About Leveraged Index Funds
Yet more and more investors are giving leveraged funds a try. The allure is obvious, it's an economical way to magnify returns without worrying about options, futures, or margin accounts. And it's not like leveraged funds have to be extremely risky when they're used in conjunction with other more conservative funds in a trading strategy. (Several years ago, we illustrated such a strategy.)
But even leveraged index funds carry a relatively high level of risk. Not only that, there are several aspects of these funds many investors don't realize until it's too late. It's not that the funds' managers are trying to put anything over one anyone, there's simply more to these funds than it may at first appear. Here's a look at two of those critical features.
Same Name, Different Results Consider two 2x S&P 500 leveraged funds, Rydex S&P 500 2x Strategy H (RYTNX) and Direxion Monthly S&P 500 Bull 2x (DXSLX). Neither of those names easily comes tripping off you tongue, but they certainly imply the funds will both deliver double the return of the S&P 500. That's correct, but there are some subtle differences. According to the fund profile, the Rydex S&P 500 2x Strategy, "Seeks to provide investment results that correspond to 200% of the daily performance of the S&P 500® Index." That's pretty straightforward. It's what you'd expect a 2x fund to do. On the other hand, the Direxion Monthly S&P 500 Bull 2x is slightly different. According to its fact sheet, "The Direxion Monthly S&P 500® Bull 2X Fund seeks monthly investment results, before fees and expenses, of 200% of the calendar month price performance of the S&P 500® Index." Unlike its Rydex counterpart, it's not necessarily trying to achieve 200% of the benchmark return every day, only monthly. Presumably there may be days where it's return is more or less than that amount, but at the end of the month, it should be 200% of the the S&P 500. Does this make a difference? You better believe it.
Normally you'd want to consider at least five years' worth of data, but in this case, that's not possible because DXSLX has only been in existence since June 2006. Although that's only a month over three and a half years through December 2009, it's enough to clearly illustrate the impact of the different strategies. Chart 1 shows the December 31, 2009 value of $100 invested in both funds and the benchmark S&P 500 on June 2006. The index is down a little over 5% or 1.45% on an annualized basis. Given that, a 2x fund should be down around 10% or roughly 3% annualized. The two funds are nowhere near that. RYTNX is down 43% over the period which translates to 14.5% on an annualized basis. That's bad enough, but DXSLX is even worse, losing 61% or 23.2% annualized. Not only did something go wrong, it went wrong in different ways for each fund. As suggested above, the two funds are invested differently. RYTNX needs to closely replicate the benchmark yet double its return each day. Because of this, futures are used to leverage the funds assets to roughly double the fund's daily return. DXSLX has a little more leeway. Because it's only seeking to double the benchmark return on a monthly basis, its managers aren't so closely tied to index. Instead, they can sample the index's main drivers and increase or decrease their level of leverage as they see fit. In this case, both approaches worked well though the end of 2007 during the end of the bull market. At that point, both were essentially right on target. But all that changed when crisis hit the financial market and stocks turned downward. RYTNX fell sharply, but DXSLX fell even more. This was a case where additional management was more dangerous than less. Because DXSLX wasn't simply replicating the index and augmenting return through futures, its specific sector and security bets acted against it. Any additional leverage also hurt as it simply magnified the index's already precipitous fall. When stocks reversed course in March 2009, a less aggressive posture prevented it from keeping pace. In essence, it fell prey to the same problems that affect all actively managed funds in a volatile market -- except its mistakes were magnified by its leverage. Then again, RYTNX the more "traditional" 2x fund also lost more than would be predicted, too. Unlike DXSLX, its loss was more attributable to factors inherent in leveraged funds than the management itself. Nevertheless, its losses still exceeded what one would naively predict. Why?
Stacked Odds
Forget about RYTNX and DXSLX and simply consider a 2x fund that does precisely what it's supposed to do. Like RYTNX, it's designed to produce 200% of the index's daily movement either up or down, and it does so without fail. Now, consider seven trading days in a volatile market, illustrated in Chart 2. Both the index and the 2x Fund start with a value of $100. On Day 2 the index rises 10% taking it $110 while the fund jumps twice as much to $120. The next day the index falls back to $100. Day 4 takes the index to $105 then back to $100 on Day 5. Days 6 and 7 simply repeat Days 2 and 3, leaving the index right back where it started at $100. Each day the leveraged fund moved twice the percentage gain or loss of the index, but it ends up worth only $95.94, a loss of just over 4%. What happened? Each day, the fund behaved just as advertised by doubling the index’s daily percentage gain or loss. When the index moves from $100 to $110 it gains 10% so the leveraged fund moves twice as much (20%) carrying it to $120. When the index falls back to $100 the next day, it loses 9.1% (10/110). The fund loses twice that percentage (2 x 9.1%) multiplied times $120, or $21.82 leaving it at $98.18. Because of Day 1’s gain, the fund’s starting value on Day 2 is higher than that of the index, so two times the percentage loss is greater than simply two times the dollar loss. In the example, this effect compounds each time the index falls. Although the index never ends a day below its starting point, the fund’s losses build after each decline. Leveraged funds will produce a loss in a volatile but flat market. But that's not all, they'll lead to even bigger losses in a falling market and they'll lag when it turns back up. When the market's going down they'll fall twice as fast. When it reverses, they'll double the percentage gain of the index, but because they're starting at a lower base they won't even come close to doubling its dollar gain. For an example of this, just compare RYTNX and the S&P 500 from March 2009 - December 2009 on Chart 1. In that period, RYTNX moved like the benchmark, but was only slowly closing the gap.
Is It Worth It? Take another look at Charts 1 and 2 and ask yourself, "Is it worth it?" Things looked good in the early months of Chart 1 while the market was rising, but notice how quickly the leveraged funds lost their lead when stocks fell. Are you that good at timing? You can see the penalty in the last nine months on Chart 1 as even RYTNX remains well below the benchmark. And even in those times when the market simply gyrates without gaining any real traction -- as has in the first two months of 2010 -- leveraged funds will likely lose ground as in Chart 2. Do you see any value in that? If you are still interested in leveraged funds, do your homework before investing real money. Again as illustrated in Chart 1, all funds with similar names are not created equally, and you may discover the differences when it's too late. Be sure you understand how the leverage works and its implications in all sorts of markets before considering buying. Like all investments (other than perhaps a Ponzi scheme), leveraged funds have their place. The wider the range of investable options, the more complete the market. The fact that such funds exist and are available to even the smallest investor doesn't necessarily mean they're appropriate for all investors. Sometimes the name doesn't tell you everything you should know, and this is one of those times. Search this site! Just enter you key word or words:
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S THE INVESTING PUBLIC HAS GOTTEN MORE sophisticated (some might say greedy), fund companies have generated new and different types of mutual funds, exchange traded funds (ETFs), and notes (ETNs). They allow retail investors to diversify their portfolios with foreign securities, real estate, and commodities. Leverage, if at least through futures, is often an integral part of these securities. Money managers are somewhat divided on their appropriateness. Some recommend them as a means of diversifying a more traditional portfolio while others warn that specialty funds -- especially leveraged ones -- aren't suitable as long-term investments but only as short-term trading devices -- and then only by the most sophisticated investors.
