When it comes to investing there are many options. For the investor looking to participate in the stock market one can obviously buy individual stocks. Over the years mutual funds became the investment of choice and still dominate in retirement accounts employers provide. Then came ETFs (Exchange Trading Funds) which are very popular for those that are ‘indexing’, a method of investing that tracks a popular index such as the S&P500. It is a very good way to be instantly diversified and seems to come into favor when the market is in a long bull phase such as the one we are in.
More recently, as the financial industry looks for ways to take advantage of the bull market, the big institutions have decided that leveraged and derivative etfs and mutual funds would attract more investors. So what does that mean when used in the context of etfs and mutual funds tracking an index? Leverage means to take on debt to achieve a goal faster whereas derivative describes an effort to achieve a goal derived from another source and many times involves a contract with other institutions.
So let’s look at one fund UOPIX and explain what it does to achieve its leverage using derivatives and is that a good thing, a problem, or just a different way to track an index and boost gains. This fund was developed by a company named ProFunds and this is their UltraNASDAQ-100 fund investor class. This fund seeks to emulate by 200% the Nasdaq 100 index. It does that by investing in securities and derivatives that ProFund Advisors believe in combination should have similar daily return characteristics of the underlying index but by twice that amount.
What they are saying is that they either borrow money, and/or have agreements with other financial institutions that somehow perform as they wish. You the investor have no idea how they do that. Even the managers of the fund who agreed to the various financial tools using derivatives only believe it will perform as designed. In normal markets this belief is likely true as they keep tweaking the agreements with other parites, again large financial intuitions, to follow the underlying index but leveraging the performance by 200%. They are using derivatives to achieve this goal. These are the same type of instruments that caused the 2008 housing collapse and subsequent deep recession.
There are many leverage funds where UOPIX is just one. There are funds that try to achieve a 300% leveraged performance. The Profund Family has devised a number of these which they call their ‘Ultra’ funds.
With the popularity of indexing and the massive influx of money into both mutual funds and efts and a substantial part of that money invested in leverage funds like UOPIX and others, no one knows how these funds will react to a steep pullback as investors try to exit their index funds. Also will the leveraged funds exaggerate the problem and if so to what extent? There has never been a test of the leverage funds to judge their performance in a panicked market like the one we had in 2008.
Be forewarned no one knows and there is very little effort to find out what these leveraged funds will do in a crisis. In fact they may even cause a crisis both in the financial market and the economy at large.