The mutual fund performance rankings for October are out on WSJ and other venues, and near the top of the list are a series of "Ultra" funds from ProShares/ProFunds and some 2X funds from Direxion.  (You'll also notice that a series of these funds are on top of the laggard ratings as well).

At first, when I learned about these leveraged investment funds, I thought that these were great ideas, as it seemed that it would be possible to get a multiple of the return of major stock indices without putting additional funds to work.  However, upon further study, I found that these shares are not good ideas for long term investors, but rather are appropriate for short-term speculation only.

One problem is that the funds do not promise the multiple of the return on a long-term basis but only on a daily basis.  The second problem is that math works against you...namely, any losses are amplified twice as much, making it much more difficult to recover from those losses.

For a mathematical example, see the exhibit below, which assumes a $100 investment in a typical stock index fund (1X) and in a 200% leveraged stock index fund (2X) :

 

Daily	1X fund	2X fund	1X fund	2X fund
index return	value	value	cumulative return	cumulative return
	$       100.00	$     100.00
2%	$       102.00	$     104.00	2.00%	4.00%
-5%	$        96.90	$      93.60	-3.10%	-6.40%
3%	$        99.81	$      99.22	-0.19%	-0.78%

 

As you can see, even though, the 2X fund gets off to a great start by returning 4%, the next day the market is down significantly and the leveraged fund falls well behind the unleveraged fund.  The next day, the market recovers, but not enough to move the leveraged fund ahead of the unleveraged index fund.

 

This exhibit helps to show that one of the keys to great long-term investing over time is avoiding large losses.  Because a 20% drop followed by a 20% gain does not get you back to your original investment (it ends up being a 4% loss), you need to avoid large losses to build wealth over the long term.  In this way, investments that deliver slow and steady gains can beat highly volatile investments that exhibit wild price swings.

 

If you were lucky enough to time the market correctly to sell the 2X fund prior to the large loss and bought it back immediately after, you would have done really well using the leveraged fund, as you would have ended up with a 10.24% return (see below).  However, very few people have the ability to time the market that well, so it's not adviseable to try.  If you are good enough to time the market with that kind of accuracy, I have a retirement account that could use your market timing abilities.

 

Daily	1X fund	2X fund	1X fund	2X fund
index return	value	value	cumulative return	cumulative return
	$       100.00	$     100.00
2%	$       102.00	$     104.00	2.00%	4.00%
-5%	$        96.90	$     104.00	-3.10%	4.00%
3%	$        99.81	$     110.24	-0.19%	10.24%