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Investing: Don’t Be Bamboozled By Leveraged Funds

28 May

Many folks today manage their own retirement accounts. It’s not a bad idea; who’s going to spend more time researching, evaluating, and monitoring investments for your nest egg than you? Of course, there are some caveats; e.g. you have to be disciplined, careful not to confuse a nest egg with a block of chips at a casino.

But assuming you are diligent and careful, you may be tempted to purchase a “leveraged” fund (you can see a list here; there are also some pseudo-leveraged funds such as VXX). These popular funds typically provide double or triple the price movement compared to the underlying share price.

When you purchase a leveraged fund, you would think that if its price increases to a higher value, and if nothing happens to the underlying components of the fund, then the higher price should remain locked in place. Unfortunately, this assumption is wrong. Leveraged funds, in essence, respond to the time derivative of the price of the underlying equity; i.e. you can’t buy and hold because prior gains will leak away. Therefore leveraged funds are generally suitable (at best) only for short term traders (those who buy and sell the funds within days or weeks).

For the average long-term investor, ET recommends: stay away from leveraged funds.

 

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