Fund Focus: Just Ignore These Funds' Triple-Digit Returns

It's not often that I spot a fund that appears to have tripled or quadrupled in just a year. So imagine my shock when, poring over a spreadsheet provided by Lipper, a unit of Thomson Reuters in Denver that tracks mutual funds, I found several funds that appeared to have delivered returns in that stellar range during the 12 months through Feb. 26.

Four members of the Direxion Funds family practically danced off my screen. In a year when the Standard & Poor's 500 Index grew by a mere 70%, Direxion Emerging Markets Bull 3X Shares (EDC) was up 345%, Direxion Technology Bull 3X Shares (TYH) 289%, Direxion Large Cap Bull 3X Shares (BGU) 208%, and Direxion Financial Bull 3X Shares (FAS) 213%.

Who's behind these gravity-defying financial instruments? Direxion Funds is run by Rafferty Asset Management, a quantitative investment firm in Boston. But they're different from mutual funds. These are exchange-traded funds, or ETFs, which are governed under the same law that created modern-day mutual funds, the Investment Company Act of 1940.

Instead of actively investing in stocks or bonds, most ETFs passively invest in indexes like the S&P 500 -- the type of benchmark that's unlikely to triple or quadruple in a year. Also unlike mutual funds, ETFs are listed on exchanges, where they trade like shares of common stock.

More Than Meets the Eye

But what explains the seemingly stellar returns of these particular ETFs? They're leveraged -- and that also makes them extremely risky.

The Securities and Exchange Commission granted Direxion exemptive relief from the so-called '40 Act on Oct. 31, 2008, allowing these fund to invest in derivatives. This can multiply the value of the stocks or bonds in the index a fund is pegged to. So a fund that's, say, three-times leveraged would chalk up a fat return of 30% if the face value of its investments increases by just 10% – but it can just as easily fall 30% if its investments lose 10% of their value. Intraday returns can be even more volatile, says Andy O'Rourke, senior vice president of Direxion.

The risk involved in these ETFs goes even further than all that would imply. Analysts who cover them say their annual returns simply aren't what they appear to be. In fact, they're completely misleading.

Direxion has set a target for each of these funds to deliver a return of 300% per day, amazingly enough. But they're so volatile that since Direxion launched the first of its 34 leveraged ETFs in November 2008, they've been known to fall at times when the indexes they're pegged to were rising, and to rise at times when the same indexes were falling, says O'Rourke.

"Only for Sophisticated Investors"

So an investor who put money into one of these funds on Feb. 27, 2009, and kept it there for a year actually might have lost money, depending on the time of day that he bought the fund and then sold it. "The math in these funds is not logical," warns Jeff Tjornehoj, a research manager at Lipper. "These funds are only for sophisticated investors."

Paul Justice, an analyst who covers ETFs for Morningstar, a fund-rating firm in Chicago, has a simpler take on how the math has worked in leveraged Direxion funds since they started trading in the midst of the financial crisis. "It's the dead-cat-bounce phenomenon when you have a crash followed by a rally," he says. "The fact that they [Direxion] even put out a yearly performance chart is misleading."

That's why the SEC advised investors last June not to leave their money in any leveraged ETFs for longer than a single day. It's also why some brokerages have banned their financial advisers from using them, says Justice.

Split-Second Timing

So what should an individual investor do with a Direxion leveraged ETF? "The first thing I would say to an individual investor who's primarily focused on a long-term buy-and-hold strategy is to not pay attention to our funds and forget they ever saw them," says O'Rourke.

To be sure, some do-it-yourselfers buy Direxion leveraged ETFs on platforms like Charles Schwab and Fidelity, says O'Rourke. But the vast majority of investors are large financial institutions that seek out volatility to maximize intraday returns, such as the proprietary trading desks of Wall Street banks and, of course, hedge funds, he says. They account for the lion's share of the approximately $5 billion in assets currently in the 34 funds. These institutions buy the funds in the morning and literally monitor them all day until they find the right moment to withdraw before the market closes. If individuals were to do this, he says, they would have to "quit their day jobs."

Tempting as that may sound, particularly in an era of 10% unemployment, you would be wise to stick to plain-vanilla mutual funds -- or at least to ETFs that aren't leveraged.