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Doubling Down

by Richard

GamblingWarning. This will be an “R” rated post.

R, as in, you wanna be Real cautious before you go supercharging your mutual fund portfolio with the new breed of derivative enhanced mutual funds and exchange traded funds.

Some background first.

Leverage is a time honored tradition on Wall Street. Using borrowed money to magnify your buying power is an exhilarating rocket ride when you have positive leverage, just as it is a harrowing, white knuckle trip when the leverage turns negative.

The traditional method for borrowing for retail investors was to open a margin account, which allows $1 dollar to have $2 dollars of purchasing power. If you wanted a bigger boost, there’s the more highly leveraged options and futures markets.

You can do this today in your taxable investment portfolios, but not in your tax deferred retirement accounts. The rules are prudently conservative, to protect you from yourself, so that you do not put your retirement security at risk.

The government’s thinking is that these accounts are for long term investment rather than speculation.

Squeaking Past The Rules

But once financial engineering was set loose, it knew no boundaries. It wasn’t long before the fund universe mimicked the leveraged hedge funds, and introduced enhanced funds, whose objective was to perform at 125%, 150%, 200% and even 250% of the selected asset class index.

And in both directions…long and short.

Three fund companies pioneered these index funds on steroids. They are ProShares, Rydex, and Direxion, and they are widely available from the no-load mutual fund marketplaces.

Further, even though most no-load funds incur a redemption fee when sold prior to 90 or 180 days, these funds typically do not have any designated holding period, or perhaps 30 days at most.

They are designed more as trading vehicles than long term investments, and have proven extremely popular with hedge funds and short term traders willing to place bold bets on short term market movements.

Proshares and Rydex are also players in the exchange traded fund and exchange traded note universe, and have been joined by other sponsors who have entered this arena.

Virtually every distinct asset class is now covered, including some recent entrants in the precious metals and commodities markets.

These funds use a combination of options, futures and swaps, long or short, to attain their targeted degree of leverage, and it is not uncommon to see ETFs move as much as 10% in a single day’s trading.

These are not your father’s safe and stodgy index funds. But there is nothing to prevent you from allocating a portion of your self directed retirement account to this breed.

I’m not saying you should. Only that you can.

And I have a sneaking admiration for the ingenuity with which they wiggled out of the margin prohibition.

The street may not always be ethical or prudent, but it is invariably creative in pushing the investment envelope.

Hedging Your Bets

One legitimate use of these funds is for portfolio hedging. If you are invested long, than using a double short broad market fund will take some of the sting out of the recent market downdraft.

I’m still nervous about their use for most investors, as I see an inherent upward bias in broad markets over time. I’m just not comfortable placing a bet against up markets, when history tell you that markets go up two out of three times.

But if you’ve got the urge to run on the fast track from time to time, and have a trading fund separate from your serious, long term money….why not?

It still gives you reasonable odds compared to your state sponsored lottery, and you save the airfare to Vegas.

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