Inverse and Leveraged Mutual Funds

Inverse Mutual Funds

Inverse Mutual Funds, which are often referred to as “short” funds, seek to deliver the opposite of the performance of the index or benchmark they track. They seek to increase in value when the market declines and decrease in value when the market rises—a result that is the opposite of traditional mutual funds. Inverse funds are often used to profit from or hedge exposure to downward-moving markets. They are designed for sophisticated investors who actively managing their portfolios on a daily basis.

Leveraged Mutual Funds

Leveraged Mutual Funds seek to deliver multiples of the performance of the index or benchmark they track. Leverage causes the value of a fund’s shares to be more volatile than if the fund did not use leverage. The use of leverage means that an investor’s returns may be significantly worse than the decline in the value of an underlying index or benchmark. Investors should be aware that such funds often do not allow for intraday orders such as stops or limits. As well, the use of borrowing or other forms of leverage provides the potential for greater gains and losses than those of the underlying index.

Inverse and Leveraged Mutual Funds

Some funds are both Inverse and Leveraged, such that they seek to achieve a return that is a multiple of the opposite performance of the underlying index or benchmark. Such funds are considered speculative and should only be used by investors willing and able to absorb potentially significant losses. As well, many Leveraged and Inverse funds are reset daily, meaning they are designed to achieve their stated objectives on a daily basis.

Therefore, Leveraged and Inverse Mutual Funds are complicated instruments that should only be used by sophisticated investors who fully understand their risks. Due to the effect of compounding, operating expenses and daily resets, the performance of Leveraged and Inverse funds over longer periods of time can differ significantly from the performance of their underlying index or benchmark.

The magnitude of this disparity is particularly high in volatile markets. Leveraged and Inverse funds that have daily resets are attempting to achieve their objectives on a daily basis, not over a longer period; as a result, investors should not expect the performance of a Leveraged or Inverse fund over a period of time to resemble the performance of the underlying index or benchmark. An investor in a 2x Leveraged fund that tracks a stock market index (such as the S&P 500®) should not expect his or her returns over one month to be 20% if the S&P 500 increases 10% over that same period of time.

Finally, investors should be aware that money managers who invest in such funds often do so as part of active trading or asset allocation strategies. These strategies often call for frequent trading to take advantage of anticipated changes in market conditions, which can increase portfolio turnover. Leveraged and inverse funds also generally have higher operating expenses as a percentage of assets than other funds.

Investors should only purchase a Leveraged or Inverse Mutual Fund if they understand the associated risks and their impact on long term performance. As mentioned, Leveraged and Inverse Mutual Funds are not appropriate for a buy-and-hold strategy, and are typically not designed to be held for more than a day or two since the daily rebalancing process may have a negative impact on returns.

In addition, investors should only purchase an Inverse Mutual Fund if they understand the risks associated with shorting and the strategy of Inverse performance, where the investment goals of the Mutual Fund are ‘Inverse’ to the performance of its benchmark, a strategy that is the opposite of how most Mutual Funds are managed.

As with any mutual fund, investors in Leveraged or Inverse Mutual Funds should obtain and carefully read the applicable prospectuses before investing.