Investor's Business Daily - Should You Own Leveraged Index Funds?

Keeping pace with the S&P 500 not good enough to reach your investment goals?

No problem. The mutual fund industry has created a breed of funds designed to outperform the market benchmark. These offerings are basically index funds on steroids. The funds are geared to surpass - either on the upside or downside - the indexes they mime by a whopping 150% to 200%. They don't do it by buying individual stocks in the index. Instead, they buy futures contracts and options on futures contracts based on an entire index, such as the S&P 500 or the Nasdaq 100. PROFUNDS ULTRA OTC, for example, aims to buy enough contracts to double the performance of the Nasdaq 100, an index dominated by tech titans like Microsoft and Dell Computer.

So how do leveraged index funds stack up against their mainstream counterparts? Last year, ProFunds UltraOTC notched a stunning 185% gain. This year it was up 29% through Tuesday. (See The Long View above.) Of the enhanced index funds that track the S&P 500, PROFUNDS ULTRABULL was tops in 1998 with a 43% return. In 1999, it's up 17%, vs. a 10% gain for the S&P 500. The stellar performances have been logged during a nearly decade-long bull market, notes Morningstar analyst Kevin McDevitt.

''It all depends on what the market does. Because they're leveraged, it's an exaggerated relationship to the market,'' McDevitt said. ''It's adding a lot of volatility. On the upside, like we've had in recent history, everyone likes it. But if the market goes down they just get mauled.''

For example, ProFunds UltraOTC fell 22% in the 10 days ended April 19. Leveraged index funds are risky. Why? Because a fund that tries to double the performance on the upside will also lose twice as much when the index falls.

Conversely, funds that short the indexes do poorly in rising markets. PROFUNDS ULTRASHORTOTC, which shorts the Nasdaq 100, is off a gut-wrenching 37% this year. PROFUNDS ULTRABEAR, which bets against the S&P 500, is off 19%. McDevitt estimates only about a quarter of the steel-stomached investors who choose these funds are long-term investors. The rest are market timers who jump into and out of them depending on which way the economic winds are blowing.

TAX EFFICIENCY

Tax ramifications are also a consideration. Some leveraged index funds have been highly tax-efficient, paying out very little capital gains or dividends last year. But depending on how frequently a fund trades, it can come with capital gains distributions, which can shrink after-tax returns. For this reason, they fit best in tax-deferred retirement accounts, such as IRAs, said Santa Monica, Calif.-based financial planner Scott Leonard. Though some investors may be lured by leveraged funds' pumped-up returns, Leonard remains leery of such short-term market timing strategies. Rather, he advocates holding fund investments over the long-term.

''Market timing doesn't work, not because the market timers fail to get out (of the fund). It's because they fail to get back in,'' Leonard said. ''I bet on the future of the world. We're going to be successful if the world is successful over the next 20 years and I'm betting that the market is going to be successful.''

Leonard prefers a different sort of enhanced hybrid, which although based on the index concept, allows fund managers some flexibility.

DANCE AROUND INDEX

Rather than leveraging their investment, these so-called ''efficient enhanced funds'' base their stock holdings on companies in an index, such as the S&P 500. But they allow themselves some leeway to trade within the index's universe.

''It's a passive asset class of funds that takes the concept of indexing and moves it to the next level - kind of quantitative indexing,'' Leonard said. Sometimes, these funds will even move outside the index in pursuit of efficiency. Say a company the fund has held for 20 years is dropped from the S&P 500 index in favor of a nearly identical firm in the same industry. The fund may choose not to sell its stake in the original company in order to avoid realizing the capital gain from the sale. Assuming both firms are similar and do not comprise a large chunk of the fund's assets, the move does not increase risk, Leonard says.

''Most of the (actively managed) funds are basically selling their stock-picking ability,'' Leonard said. ''These are selling their observance of the way markets work and not getting caught in the inefficiencies that index funds have.''

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