The Performance of Leveraged Funds Can Be Ugly

(MoneyWatch)  On Wednesday, I reviewed Jason Zweig's new book The Little Book of Safe Money. It's an excellent book, and one part in particular caught my attention -- leveraged funds.

Every investor has the potential for a good investment experience -- assuming you're willing to accept market returns. The most effective way to do this is to build a globally diversified portfolio of passively managed funds (such as index funds).

Not surprisingly, however, many aren't content to settle for market returns. Leveraged funds are one of the products Wall Street's sales and marketing machine has created to entice investors with the tantalizing "promise" of outperformance. Leverage refers to the concept of increasing, multiplying or magnifying the return of an investment through the use of borrowed funds. Salespeople hawk these investments with pitches like: "If the market returns 10 percent, why settle for that rate when you can earn 15 percent using the power of leverage?"

Zweig's book provided several examples of why leveraged funds should be avoided:

• For the 12 months ending July 2009, 55 percent of leveraged ETFs and more than 85 percent of ultra-short ETFs turned their investors inside out -- delivering long-term losses when they should have produced gains, and gains when they should have produced losses. More than half the time, investors got the exact opposite of what the daily returns promised.
• In 2008, the Dow Jones Index of U.S. Energy stocks lost more than 37 percent. The ProShares UltraShort Oil & Gas ETF (DUG), designed to deliver twice the inverse of that index (or +74 percent) actually lost 9 percent. Adding insult to injury, it paid out a short-term capital gain of more than $6 per share.
• In 2008, emerging markets fell by 49 percent. Instead of gaining twice the inverse of the index (98 percent), the ProShares UltraShort Emerging Markets Fund (EEV) actually lost 24.9 percent.
• In 2008, real estate fell 40 percent. Instead of making twice the inverse of the index (80 percent), the ProShares UltraShort Real Estate Fund (SRS) actually lost 50 percent.
• In 2008, Chinese stocks fell 48 percent. Instead of making twice the inverse of the index (96 percent), the ProShares UltraShort China Fund (FXP) actually lost 53.6 percent.

My book The Only Guide to Alternative Investments You'll Ever Need included a chapter on leveraged funds, which I placed in the "ugly" category. If I was writing my alternative investment book now I would have to add a new category beyond ugly. A more fitting category for leveraged funds would be toxic waste.