Although mutual funds are not traditionally considered leveraged financial products, they can achieve better results by using some degree of leverage.
Indeed, products are emerging that attempt to take advantage of leveraged hedge funds within mutual fund packages.
However, all mutual funds are subject to liquidity requirements and there are strict rules regarding the level of leverage they can use.
Nevertheless, the prospect of faster returns by borrowing to increase a fund’s position is attracting many investors to leveraged mutual funds.
What is Leverage?
In its simplest form, leverage is debt. When a company leverages itself, it means it takes on debt to achieve a goal faster than it could with its own capital alone.
In investing, leverage means borrow funds to buy additional securities, thereby earning a larger profit than usual.
How it Works
Leveraged investing uses debt to increase profits in a short period of time. By increasing the amount of investment, the potential profit also increases.
Conversely, you may be liable to your creditors if the investment fails. For this reason, leverage is inherently very risky. But as investors know, with risk and volatility come the opportunities for huge profits (or catastrophic losses).
How do Leveraged Mutual Funds Work?
The U.S. Securities and Exchange Commission (SEC) severely limits the percentage of a mutual fund’s portfolio that can be financed with debt.
This is because mutual funds are, by definition, very liquid, and the higher the debt-to-equity ratio, the less liquid the fund becomes.
Hedge funds are known for using enormous leverage to take advantage of highly illiquid investment opportunities that require a lot of capital and patience. Mutual funds are designed to be easy to buy and sell, and affordable to a wide range of investors.
Leveraged mutual funds therefore attempt to split the difference between these two asset classes by employing lower leverage and using less traditional tactics such as short selling and arbitrage strategies.
Allowable Leverage Rates
By law, the maximum leverage for an open-end mutual fund is 33.33% of your portfolio value. If your portfolio is worth $1 million, you can borrow up to $333,333 to increase your purchasing power.
However, if the assets in your portfolio perform poorly and the fund loses value, you may need to reduce your leverage to get within the required limits.
IMPORTANT: Leverage can have adverse effects on investors and you may be liable for more than you invested. If your portfolio is not leveraged and you incur a loss, it is only your own money that is at risk. But if you borrow money to buy securities and the market goes against you, you may have to repay the borrowed money with money you don’t have.
What Types of Mutual Funds Use Leverage?
Most leveraged mutual funds fall into the category of leveraged index funds. This simply means that they try to achieve a certain multiple of the return generated by an index. For example, a 2X S&P 500 fund is specifically managed to achieve twice the return of the S&P 500.
Conversely, some leveraged funds, or so-called inverse funds, attempt to achieve the inverse of the index return.
If a fund manager believes the S&P 500 will lose fee in the coming year, for example, their fund can be aimed toward producing a earnings this is two times the amount of the index`s loss. A 10% drop for the S&P way a 20% earnings for shareholders if the whole thing is going to plan.
Other leveraged mutual budget appoint a 130/30 method, in which they borrow $30 for each $a hundred of portfolio fee and use it to quick a few shares whilst going lengthy on others to beat a given benchmark. Other budget are much less aggressive, using a 120/20 method instead.
Are Leveraged Mutual Funds Riskier Than Typical Mutual Funds?
Yes, they bring about greater hazard because of the delivered quantity of publicity they benefit with borrowed money. This can enlarge now no longer simply their holdings and capability profits, however capability losses, as well.
Are Leveraged ETFs Safer Than Leveraged Mutual Funds?
Generally, no. In fact, they may be visible as riskier. That’s due to the fact such ETFs can also additionally have a extra quantity of leverage than leveraged mutual budget. Plus, not like mutual budget, they music marketplace overall performance during the buying and selling day and can stumble upon especially volatile price moves that may bring about substantial losses.
How Do I Know if a Mutual Fund Is Leveraged?
You can take a look at a fund`s prospectus to study whether or not it makes use of debt. The fund call additionally can also additionally tip you off with phrases that suggest amplification, such as “leveraged,” “2x,” or “ultra.”
The Bottom Line
Mutual price range, even though designed to be a liquid investment, are allowed through the Investment Company Act of 1940 to apply leverage (or borrowed funds) to probably decorate their returns.
However, the quantity that they will use is exactly limited because of the chance of leverage to extend losses and the want mutual funds should make redemptions.
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