Personal Finance takes center stage as mutual-fund reporter Ilana Polyak chats live with Faraz Naqvi, co-manager of the (DRBNX) Dresdner RCM Biotech fund and the (DGHCX) Dresdner RCM Global Health Care fund. Have your questions ready for this exclusive free chat on TheStreet.com Tuesday Aug. 8 at 5 p.m. EDT.
It has been a tough year for most tech investors to make much, even tougher if you were hoping for goosed-up returns. Just ask the folks at
, the Bethesda, Md.-based fund shop with
-based offerings that use leverage, or borrowed money, to amplify returns by two on both the upside and the downside.
pointed out that using leverage has landed the
ProFunds UltraOTC and the
ProFunds UltraShort OTC in the doghouse.
The funds are pretty deep in the red -- UltraOTC is down 26% and UltraShort OTC is down a whopping 38.1% this year through Aug. 4. Both funds track the
, the top companies by market capitalization that trade on the Nasdaq, but UltraOTC uses leverage to get a two-times exposure to the Nasdaq 100, while UltraShort OTC uses it to get two times the inverse of the index. The funds actually buy futures contracts, not the stocks of the index. In the short fund, the managers sell borrowed shares of the contracts, hoping the price will decline by the time they repurchase them in the future. But if the price rises, the funds lose money.
One would think that at least one of these funds, most likely the short fund, would be performing well in the current market. The reason the funds aren't behaving like the index, which is down 2.4% for the year to date, and are in the red, has to do with the way the returns are compounded.
"As strange as that sounds, these funds are doing exactly what they're supposed to," says William Seale, director of portfolios at ProFunds, a shop that caters to market timers and trigger-happy investors.
The funds' returns are compounded
, not over a longer period of time. That's the reason that last year the Nasdaq 100 index rose 102%, but the OTC fund went up 230%. The short fund, though, went down 80.4%, far from the expected 200% decline.
An example might help: On a given day, the Nasdaq UltraOTC fund has a net asset value of 10.00. That day, the Nasdaq 100 rises by 5%, so the fund rises by 10%. The following day it starts off with an NAV of 11.00 and the index rises again by 5%, adding 10% to the fund's NAV. That gives it a closing NAV of 12.10. On the third day, the index again rises by 5%, so the fund goes up 10%, giving it an NAV of 13.31. At the end of the three-day period, the fund has gone up 33.1%, while the Nasdaq 100 has gone up just 15.8%, which is less than half of the fund's gain. If you repeat that for an extended period of time, the disparity grows wider, as those little bits of change pile up.
On the way down, the returns are just as amplified. If an investor had put their money into the UltraShort OTC on those three days, they'd be down 27.1%, less than the 31.6% you'd expect.
In a choppy market, the funds mirror the indices even worse. "If in one day they lose 5%, they then adjust the portfolio," explains Jeff Merriman, vice president of
Merriman Capital Management
in Seattle. "When the market goes up again, it may not make up as much as it lost the previous day."
Other indices such as the
are also down for the year, but because that index hasn't had the wild up- and down-swings, the
ProFunds UltraBull and
UltraBear funds, are just down 8.01% and 1.1% respectively.
, two other fund families that cater to market timers, have seen weakness as well. The Potomac funds, which are leveraged at just 125%, are down 8.2% for
OTC Plus and down 12.9% for the
OTC Short fund.
Rydex just recently inaugurated its two-times funds --
-- that began trading in June. Velocity, the firm's Nasdaq 100 long fund, is up 20%. Venture 100, the short fund, is down 40.5%, having missed the spring-time weakness.
Jonas Ferris, founder of
, a Web site specializing in small and new mutual funds, adds that the funds would more closely mirror each other in a market that was steadily rising or declining. "The up and down movement screws the whole thing up," he says. "It's not a blatant error."
Merriman's firm studied the issue about a year ago and found that ProFunds had a better long-term track record on the long side than on the short. For the long funds, the firm was able to capture about 85% of the performance in the respective indices, but the bear funds only captured 80%. But day-to-day, Merriman found that ProFunds mirrored and amplified the changes in the indices almost perfectly.
Investors should proceed with caution. While the UltraOTC fund might be a consideration as a long-term holding, expect volatility and huge price swings. Even the gang at ProFunds doesn't recommend the bear fund as a buy-and-hold strategy.
"The UltraShort fund is sort of like someone you date, not marry," says Michael Sapir, ProFund's chief executive.