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Should You Be Using Leverage in Your Portfolio?

I recently got a great question from a reader that I thought I would address in this week's post. His question was two-fold. First, he asked if the warnings I made about the use of leveraged ETFs in July of last year also applied to leveraged mutual funds. Second, he asked for my thoughts on the advice given in Lifecycle Investing -- a recent book by Yale professors Ian Ayres and Barry Nalebuff -- which, in part, advocates the use of leveraged mutual funds or ETFs.

If you didn't read that earlier article, I wrote that the intermediate- to long-term performance of leveraged ETFs can differ significantly from the performance of the index they're designed to reflect. The differences can be so substantial that FINRA -- which is an independent regulator of the securities markets -- took the unusual step last summer of warning investors that such funds were unsuitable for holding periods of longer than one day.

So does that warning apply to leveraged mutual funds as well? Unequivocally, yes. The issue with these funds is not something that's inherent in the ETF structure. Rather, the problem lies in the impact of compounding. As the indexes these funds track move up and down over time, the returns these funds earn will inevitably fall short of their benchmark.

That fact explains why the prospectuses of both the mutual fund and ETF version of ProFunds/ProShares leveraged S&P 500 investments contain the following language:

The Fund is different than most funds (exchange-traded funds) in that it seeks leveraged returns and only on a daily basis. The Fund also is riskier than similarly benchmarked funds (exchange-traded funds) that do not use leverage. Accordingly, the Fund may not be suitable for all investors and should be used only by knowledgeable investors who understand the potential consequences of seeking daily leveraged investment results.
So what are those "potential consequences"? Consider the returns presented in the table below, which show the performance of leveraged ETFs and leveraged mutual funds against the S&P 500 over the past three and five years.
Fund/ETF Avg. Annual Return,
3 years ended 11/4/2010
Avg. Annual Return,
5 years ended 11/4/2010
ProFunds UltraBull mutual fund

(2x S&P 500 return)

-20.15 -14.15
ProShares Ultra S&P 500 ETF

(2x S&P 500 return)

-19.50 N/A
ProFunds UltraBear

mutual fund

(2x inverse S&P 500)

-15.40 -15.25
ProShares UltraShort S&P 500 ETF

(2x inverse S&P 500)

-14.86 N/A
S&P 500 -4.68 2.15
As you can see, regardless of the structure, the returns provided by these investments over the past three years have fallen well short of the return provided by the benchmark they were tracking, and far short of the return that an investor might have expected. Indeed, there is no better testament to the impact of compounding on these funds than the fact that the five year returns of the bull and bear mutual funds are just over a percentage point apart, while both trail the actual S&P 500's return by more than 16 percentage points.

My reader also asked about using these funds in a strategy advocated by professors Ayers and Nalebuff. I'm not an advisor, so my colleagues Larry Swedroe and Allan Roth are far better-equipped to answer this question, but I'm happy to add my own two cents.

While it may make sense, on a theoretical level, for younger investors to use leverage to capitalize on the fact that they have many years of earnings ahead of them, I think that doing so in practice, particularly with leveraged instruments such as those discussed here, is fraught with peril.

Using these leveraged instruments as part of a long-term strategy requires an investor to be hyper-vigilant, rebalancing their account on a near-daily basis to protect against the sort of performance depicted in the table above.

But even leaving that issue aside, the reason that most investors fail to reach their investment goals, in my limited experience, is far more likely to be behavior-related than investment-related. The problem, in my opinion, is less that investors are choosing the wrong funds or even the wrong allocation (though both can cause problems), and much more that investors are doing the wrong thing at the wrong time.

In other words, an investor who faithfully sticks with a 50/50 stock/bond allocation using actively managed funds is capable of accumulating a decent nest egg over time (even if the amount accumulated is less than it might have been). But an investor who follows their emotions into and out of the market over the years -- loading up on stocks when the market is rising, and bailing out when it falls -- is likely to fall well short of their goals no matter what kind of funds they use.

Unfortunately, evidence indicates that a significant portion of investors behave precisely this way. Buying and holding is a very difficult thing to do. Which is why I'm extremely skeptical that encouraging investors to use leverage -- which will only amplify the market's volatility -- will help them achieve their goals. In my opinion, it will only increase the odds that they'll do precisely the wrong thing at precisely the wrong time.

All of this reminds me of an article that the late Peter Bernstein wrote at the height of the tech bubble. At a time when most investors were seeking to maximize their return, Bernstein advocated a more modest approach in the form of a 60/40 stock/bond allocation, bought and held for the long term. In defending this portfolio against others that promised richer rewards, Bernstein wrote that "few decisions in life motivated by greed ever have happy outcomes."

Truer words were never written, and it's a good idea to keep Bernstein's wisdom in mind as you put together an investment portfolio designed to reach your long-term goals.

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