Home > Investor Resources > Mutual Fund Essentials  > Leveraged and Inverse Investing:A Lesson in Compounding

At first glance, some investors might make the assumption that a leveraged or inverse fund will produce a simple multiple of an index’s performance. For example, if the S&P 500® was up 5% in a single month, an uninformed investor might assume that a fund leveraged two times to the S&P 500 would deliver a 10% return during that same period. However, that simple assumption is incorrect. Compounding plays a major role in the ending performance of most funds, but especially leveraged or inverse funds.

Leverage Magnifies Compounding

As leveraged investments magnify the impact of market movements, the results of compounding are also magnified. In an upward- or downward-trending market, a leveraged investment that is on the correct side of the trend will see magnified end results, while one on the wrong side of the trend will see magnified losses. When the underlying index is volatile, the leveraged fund will amplify this volatility.

An Example of Leveraged and Inverse Leveraged Compounding

The following graphs further illustrate the impact of leverage and inverse leverage on fund performance in comparison to the performance of the fund’s underlying index in three different markets—upward, flat and downward. Each of the three graphs shows a simulated hypothetical of the one-year performance of an index (1x Index) compared with the performance of a fund that perfectly achieves its investment objective of exactly twice (200%) the daily index returns (2x Index) and the inverse of exactly twice the daily index returns (Inverse 2x Index).

Each of the graphs assumes an index volatility of 20%. An index’s volatility is a statistical measure of the magnitude of the fluctuations in the returns of an index. For example, the average of the most recent five-year historical volatility of the S&P 500 Index is 16.05% for the period ended 12/31/2009. The S&P 500 Index’s volatility may be more or less significant at any given time. The indices underlying Rydex SGI funds benchmarks have different historical volatilities, which may be more or less significant than the index volatilities assumed in the graphs shown. The hypothetical graphs are meant to demonstrate the effects of leverage and inverse leverage and are in no way indicative of the actual performance of any Rydex SGI funds.

In order to isolate the impact of leverage, these hypothetical examples assume (i) no tracking error; (ii) no dividends paid by the companies included in the underlying index; (iii) no expenses; and (iv) borrowing and/or lending rates (required to obtain leverage) of 0%. If tracking error, fund expenses and borrowing and lending rates of greater than 0% were included in the graphs, the fund’s performance (1x Index) would be lower than that shown. The index is unmanaged and is not available for direct investment.

As illustrated by these simple examples, the effect of leverage can make it difficult to form longer-term expectations or judgments about a leveraged fund’s performance given only the returns of the unleveraged index. As a general rule of thumb, more leverage will magnify the compounding effect. In addition, periods of high volatility in an underlying index will also cause the effects of compounding to be more pronounced.

Inverse and leveraged Funds are not suitable for all investors. •These Funds should be utilized only by investors who (a) understand the risks associated with the use of leverage, (b) understand the consequences of seeking daily leveraged investment results, (c) understand the risk of shorting, and (d) intend to actively monitor and manage their investments. •The more a Fund invests in leveraged instruments, the more the leverage will magnify any gains or losses on those investments. •Inverse Funds involve certain risks, which include increased volatility due to the Funds’ possible use of short sales of securities and derivatives, such as options and futures. •The Funds’ use of derivatives, such as futures, options and swap agreements, may expose the Funds’ shareholders to additional risks that they would not be subject to if they invested directly in the securities underlying those derivatives. •Short-selling involves increased risks and costs. You risk paying more for a security than you received from its sale. •Leveraged and inverse Funds seek to provide investment results that match the performance of a specific benchmark, before fees and expenses, on a daily basis. Because the Funds seek to track the performance of their benchmark on a daily basis, mathematical compounding, especially with respect to those Funds that use leverage as part of their investment strategy, may prevent a fund from correlating with the monthly, quarterly, annual or other period performance of its benchmark. Due to the compounding of daily returns, leveraged and inverse Funds’ returns over periods other than one day will likely differ in amount and possibly direction from the benchmark return for the same period. For those Funds that consistently apply leverage, the value of the fund’s shares will tend to increase or decrease more than the value of any increase or decrease in its benchmark index. The Funds rebalance their portfolios on a daily basis, increasing exposure in response to that day’s gains or reducing exposure in response to that day’s losses. Daily rebalancing will impair a fund’s performance if the benchmark experiences volatility. Investors should monitor their leveraged and inverse Funds’ holdings consistent with their strategies, as frequently as daily. •For more on these and other risks, please read the prospectus.

This piece is intended to be for information purposes only. Investors should discuss these concepts and their personal financial situation with their financial advisor or advisors prior to making any investment decisions.

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The funds are distributed by Rydex Distributors, LLC (RDL). Guggenheim Investments represents the investment management businesses of Guggenheim Partners, LLC (GP), which includes Guggenheim Partners Asset Management, LLC (GPAM) and Security Investors, LLC (SI), the investment advisors to the referenced funds. Rydex Distributors, LLC, is affiliated with GP, GPAM and SI.