Boiled down to its essential elements, successful investing is a basic three-step process. First, find an investment with the levels of risk and reward that are attractive to you. Second, make periodic purchases of that investment over time. Third, hold on for the long term. Those who have followed those simple concepts have outperformed quite a few investors who've sought more complicated ways to invest.
However, not everyone has the time or patience to wait the years and decades that have sometimes been necessary in order to earn good returns from the financial markets. Whatever the reason for their impatience, these investors are willing to take additional risk in order to make more profit. Recently, as exchange-traded funds have become increasingly popular, funds that use leverage to amplify their performance have come into vogue. During periods of ongoing positive performance, such as the second half of 2006, using leverage to increase returns seems like a no-lose situation.
How leveraged funds work
The idea behind leveraged funds is similar to the concept of margin in a standard brokerage account. Most brokers allow individual investors to select an option on their brokerage accounts that lets them borrow money from their broker to buy more stocks. For example, if you have a margin account with $10,000 in a particular stock, you could buy as much as an additional $10,000 of that stock, doubling your exposure without requiring any more of your own money. If the stock rises, the resulting profit from your margin position is roughly twice as much as it would be without margin. But if the stock falls, you'll lose twice as much money. In either event, you always have to repay the margin loan eventually -- with interest.
Leveraged funds use similar techniques to increase their sensitivity to price movements in a stock. Some funds issue preferred stock to institutional investors, which raises capital that the fund can then reinvest in whatever asset class it's chosen as its specialty. The dividend payments the fund must make to its preferred shareholders are analogous to the interest payments an individual investor pays on a margin loan. Alternatively, funds can use various derivatives, including options, futures, and swaps, to create portfolios whose prices act the same as a leveraged portfolio's price would.
Leverage isn't just for stocks
At first glance, you might expect to see only equity funds use leverage, since leverage increases a portfolio's risk, and stocks are the riskiest asset class that many investors ever own. You can certainly find leveraged funds that specialize in equities, such as ProShares Ultra QQQ (AMEX: QLD ) for the Nasdaq 100 index, or the Rydex Dynamic Dow Fund (FUND: RYLDX ) for the Dow Jones Industrial Average.
Surprisingly, though, you can find leveraged funds in other asset classes as well. For example, most investors consider municipal bond funds some of the most conservative investments available. They are often backed not only by tax or other government revenue, but also by a bond insurance company like MBIA (NYSE: MBI ) , making the possibility of default less worrisome than with corporate bonds. Nonetheless, there are dozens of leveraged municipal bond funds available to investors, such as Nuveen California Premium Income Municipal (AMEX: NCU ) and PIMCO Muni Income (NYSE: PMF ) . If a municipal bond fund succeeds in earning more interest on the bonds it buys than it must pay on the money it borrows, the fund will increase its overall return.
If you're looking for leverage, you can find funds in nearly any asset class that use it. Aberdeen Global Income (AMEX: FCO ) is a leveraged global bond fund, while AIM Select Real Estate (NYSE: RRE ) uses leverage to enhance returns on its real estate investments.
Is leverage for you?
Whether you should use leverage depends on several factors. The most important is how much risk you're willing to take with your money. Because nearly every portfolio includes investments that span a wide spectrum of risk levels, having one leveraged fund doesn't mean that you're taking too much risk overall. On the other hand, if you own nothing but leveraged funds, you may be putting your savings at serious risk of a decline from which it may be difficult, if not impossible, to recover.
Moreover, the fund's cost of maintaining a leveraged position is also an important element in your decision. The most effective use of leveraged funds is in making short-term trades, because short holding periods minimize the cost of leverage. Over long periods of time, it's tougher to maintain an edge over a leveraged fund's financing costs. In addition, even if you do succeed in getting better performance, you can definitely expect a bumpier ride getting there.
Lastly, not all leverage is created equal. When considering a leveraged fund, it's important to understand how it's likely to respond to both positive and negative moves in its holdings. Small amounts of leverage may provide so little enhancement to your return that it's hardly worth the trouble, while highly leveraged funds may endanger substantial amounts of your principal when prices move even modestly against you.
In general, leveraged funds aren't an essential element of any investor's long-term portfolio. For short-term bets on market movements, they can enhance your returns substantially. In the long run, however, most investors may be better off taking the slow and steady approach to accumulating assets over time.
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Fool contributor Dan Caplinger doesn't use leverage very often, and he doesn't own shares of the companies and funds mentioned in this article. The Fool's disclosure policy is risk-free.