The average investor may view funds using leverage and other exotic trading strategies as opportunities to boost returns quickly. In reality, these strategies are usually costly and can be downright harmful if not used properly.

Very few mutual funds short sell stocks or use leverage because these strategies are mostly inconsistent with their buy-and-hold nature. The ones that do could see their fund returns impacted significantly.

In case if you are wondering whether mutual funds are right for you at all, you should read about why mutual funds, in general, should be a part of your portfolio.

Most mutual funds use the straightforward strategy of buying securities they believe will rise in value and then selling them at a later time when (hopefully) they do. More complex strategies involve betting on prices falling instead of rising in value, or attempting to multiply the returns of an underlying index.

While most mutual funds hold some combination of stocks, bonds and cash, funds utilizing these inverse and leveraged strategies usually make heavy use of options or futures contracts instead. They’re helpful in that they are generally the easiest way to obtain long or short exposure to an entire index or sector without making a huge initial investment, but there can be significant costs involved in establishing positions. Many leveraged funds use short-term contracts, typically around one month until expiration, and must continue reestablishing those positions every month. This continuous buying pattern costs money that eats into shareholder returns, something that typical buy-and-hold mutual funds don’t experience.

Read about why active fund managers find it difficult to beat the market.

ProFunds and Direxion are two of the largest leveraged fund providers with many of their offerings designed to produce as much as three times the daily returns of their underlying index. A few of the more popular inverse and leveraged funds, along with their simpler mutual fund counterparts, are included in the table below. The returns are calculated as of July 7, 2017.

Funds Deploying Complex Strategies

Funds Deploying Simple Strategies

The first that you may notice when looking at the simple index funds compared to the complex funds is the difference in expense ratios. As mentioned earlier, leveraged funds do a lot of trading to buy new contracts that replace the ones that expire. The ProFunds UltraBear Fund, for example, has an annualized turnover rate of nearly 1,300%. The simple index fund, on the other hand, does very little trading, which is what helps it keep its expense ratio so low.

The other major difference is the complex funds’ seemingly imperfect correlation to the returns of the underlying index over longer periods of time. The objective of many leveraged funds is to perform relative to the daily returns of their benchmark indices. On a typical day, the UltraBear Fund could be reasonably expected to drop 2% on a day when the S&P 500 rises by 1%, but over a longer holding period, expense ratios and other factors begin to impact the holding period returns.

Perhaps the biggest factor working against leveraged and inverse products is the high cost. Some funds using complex strategies can carry expense ratios of 2% or more, a significant headwind when trying to maximize shareholder value, and those expenses eat into shareholder returns. Futures and options are also fairly complicated instruments and largely misunderstood by many investors, making them particularly susceptible to being used improperly.

One of the factors that impacts the expected returns of leveraged funds is simple math. Let’s imagine that XYZ fund is highly volatile. On a Monday, it rises 33%, but on Tuesday, it falls 25%. Over that two-day period, an investor in XYZ would have broken even.

(1 + 0.3333) * (1 – .25) = 1.000

If a 2x leveraged fund based on XYZ were to perform exactly as would be expected on a daily basis, the equation changes to this.

(1 + 0.6667) * (1 – .50) = 0.833

The investor holding the traditional fund would have experienced a 0% return, while the investor holding the 2x leveraged fund would have lost nearly 17%. This is an extreme example, but it demonstrates how leveraged funds can drop in value even as the underlying index remains flat overall. The greater the volatility, the greater the long-term performance erosion.

On the surface, funds using complex strategies are not exactly what they seem.

Investors who see the S&P 500 return 8% per year and assume that a 2x leveraged S&P 500 fund would return 16% per year will likely be disappointed. The high cost of funds using options and futures make them less than ideal for long-term investment. The average investor is probably better off sticking with traditional mutual funds.

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