New ETF Offers Leverage and Pitfalls

Everyone knows someone who blew up his account due to improper use of leverage. The term "leverage freak" comes to mind. But there are ways to use leverage without dealing yourself a financial death blow.

ProFunds just launched a series of ETFs that are designed to capture twice the move of the underlying indices mimicked. Because the most common equity benchmark is the S&P 500, I'll comment on the ProShares Ultra S&P500 fund(SSO).

Here are the nuts and bolts: The fund will charge a 0.95% fee and wll aim to capture double the movement of the S&P 500 index through leveraging with index futures and options. The prospectus goes to great lengths to try to explain the various ways it will overshoot and undershoot the goal of capturing double the index's move -- and the prospectus is a must-read for anyone considering this fund.

I'm more interested in the strategy of the fund than its nuts and bolts, however. The goal of ProShares Ultra S&P500 is to beat the market, but there are a couple of flies in the ointment. First, let's look at how this ETF could be used in a portfolio.

How It Could Work

Assume for a moment that the fund perfectly captures double the returns of the S&P 500. In that case, a portfolio of 50% in this ETF and 50% in the money market would beat the market by the amount of interest income.

Now try it with some numbers: If the S&P 500 rose by 5% over the next 12 months, the ProShares Ultra S&P500 would go up by 10%. The remaining cash could be in a money market yielding 4%. That 4% would deliver an additional two percentage points of return to the total portfolio, thus outperforming the market. If interest rates move higher, as appears likely, the extent to which the concept outperforms would improve.