NEW YORK -- Margin investing was demonized last spring when the stock market tanked and stories circulated about investors who borrowed money and then lost their shirts after trying to get in on that "sure thing" Internet stock.
Investing on margin has always been risky, but greater risk means greater rewards.
Bearing that in mind, a growing number of investors are turning to something called leveraged mutual funds, which use sophisticated but perilous investment strategies in an effort to outperform traditional funds.
"They've exploded," said Paul Merriman, a Seattle-based investment adviser. "Obviously there's a market for what they're offering."
Merriman said investors frequently turn to leveraged funds because they can be held in individual retirement accounts, or IRAs, that offer tax benefits not extended to regular fund portfolios.
Fund analysts don't universally discourage small investors from dabbling in leveraged funds. But they are unanimous on one thing: Leveraged funds are far riskier than traditional funds.
"Our position is that, boy, this is really risky business. You need some kind of a defensive strategy to protect yourself against major losses," said Merriman, who has written extensively on the subject at his Web site, www.fundadvice.com.
Burt Greenwald, a Philadelphia-based fund consultant, echoed that sentiment. "Leveraged funds accentuate the upside potential when the market is going up," he said. "But if the market goes south, it has the same effect in the opposite direction."
This niche of funds, first introduced by Rydex Funds in 1993, not only leverage assets to reap greater returns, but also employ complicated techniques designed to make money for investors whether the market goes up or down.
Rockville, Md.,-based Rydex, for example, offers one fund for investors who are betting that the market will rise and another for those betting the market will fall.
The Nova fund leverages 50 percent of its assets in an attempt to outperform the S&P 500 index by 50 percent. So if the market rises by 10 percent, the Nova fund should rise 15 percent.
The cleverly named Ursa fund, meanwhile, rises when the market falls, using a technique known as shorting the market. Ursa is Latin for bear, as in a bear market.
Other fund companies that offer these types of products include, ProFunds, based in Bethesda, Md., and Potomac Funds of Alexandria, Va., both of which were founded by ex-Rydex staffers.
To emphasize the danger inherent in leveraged funds, Merriman offered an example of how investors can lose their entire investments during a volatile market stretch.
Say an investor puts $10,000 in ProFunds' UltraOTC fund, which seeks through leveraged investing to double the performance of the technology focused Nasdaq 100 index. If the index rises by 50 percent, the fund rises by 100 percent, meaning investors double their money. But if the index falls by 50 percent, which nearly happened last spring, investors lose everything.
Tales of leveraged investors who got creamed when the market turned on them are plentiful, none more publicized probably than that of well-known hedge fund company Long-Term Capital Management.
For most of the 1990s, Long-Term Capital Management leveraged much of its $7.5 billion in assets to generate huge returns for its wealthy investors.
But when global financial markets soured late in the decade, the Nobel laureates running the firm saw their strategies backfire and their remarkable gains turn quickly into equally remarkable losses. The firm nearly went belly up and had to be rescued in a well publicized bailout by a group of Wall Street firms.
The moral of the story is that leveraging is great when you guess right.
"But when you guess wrong and you're leveraged, you can get killed," fund consultant Greenwald noted.
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