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 WorkAssume 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.
How It Couldn'tBack to the flies in the ointment, which I believe could extend to all the entries in this series of leveraged funds from ProFunds: The fee of 0.95% will not be a huge drag when the market has a big move, but in a year when the market is up single digits, the fee could be noticeable. The bigger issue is the potential tracking errors. As money comes and goes from the fund, cash builds up temporarily for one reason or another. Distortion in the markets where the fund executes its trades, and perhaps some other reasons, will make trying to game the tracking error difficult to impossible for the managers, probably yielding some degree of disconnect between the fund and the index. Every strategy has flaws, and for my money, this potential tracking error is the biggest flaw in precise execution of this concept. It makes sense to think that a similar product will be available one day on a foreign-equity benchmark like the MSCI EAFE index. This would open the door to more diversification with the flexibility of a large cash position.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider ProShares Ultra S&P500 fund to be a small-cap stock. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.