How Short Selling and Leverage Impact Your Mutual Fund Returns

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complicated route to money

Mutual Fund Education

How Short Selling and Leverage Impact Your Mutual Fund Returns

David Dierking Jul 18, 2017



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.


The Complexity of Inverse or Leveraged Strategies


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.


Complex Strategies at Play


Funds Deploying Complex Strategies



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.


Why Complex Strategies May Not Be Worth It


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.


The Bottom Line


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.

Be sure check our News section to keep track of the recent fund performances.


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