Monday, October 15, 2012

Mutual Funds Holding Leveraged and Inverse Leveraged ETFs

By Tim Dulaney, PhD

While looking through recent SEC filings, an updated prospectus happened to catch our eye.  The prospectus offers updated information concerning the investment strategy and details of two mutual funds: USFS Funds Limited Duration Government Fund (USLDX) and USFS Funds Tactical Asset Allocation Fund (USFSX).

The fund management company -- Pennant Management, Inc. -- states in this prospectus that "[USFSX] may invest up to 33% of its assets in leveraged ETFs and inverse ETFs, up to 10% of its assets in options, and up to 5% of its assets in futures."  An earlier version of the prospectus stated that the fund would "invest extensively" in leveraged and inverse leveraged ETFs, but didn't specify an upper bound on this allocation.  According to the fund's fact sheet, the fund had total net assets of about $17 million as of June 2012 and has underperformed the S&P 500 since the fund's inception in November of 2009.

We were curious how much disclosure such a large allocation to leveraged and inverse leveraged ETFs is given concerning the suitability of this allocation for retail investors -- which we've written extensively about on this blog. The prospectus has the following disclosure concerning daily rebalancing in leveraged and inverse leveraged ETFs
Such ETFs often “reset” daily, meaning that they are designed to achieve their stated objectives on a daily basis. Due to the effect of compounding, their performance over longer periods of time can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time. This effect may be enhanced during the periods of increased market volatility. Consequently, leveraged ETFs may not be suitable as long-term investments.
The prospectus also indicates that USFSX may "buy and sell investments frequently" possibly leading to higher expenses and increases in taxable short-term capitals gains.  If a high-turnover fund invests in leveraged ETFs, this effect could be magnified because leveraged ETFs often have higher turnover rates due to their daily rebalancing (see, for example, the prospectus for the Direxion Shares ETF Trust).

The current asset allocation indicates that this mutual fund has no allocation to leveraged and inverse ETFs, but that's not really the point.  Mutual funds that might allocate such a large portion of their assets to such ETFs should make a more concerted effort to educate potential investors as to the risks involved in the underlying investments.

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