Leverage Shakes Up Mutual Funds, Which Discover a Strategy's Downside

By SHEFALI ANAND In recent years, more mutual funds have used borrowed money to juice returns and lure investors. Now, they are discovering the downside of leverage, and some are cutting back. Early last year, Wall Street was heavily promoting several new types of funds that rely on borrowing money. These include so-called 130/30 funds that aim to amplify market returns by betting against some stocks, as well as "leveraged index" funds, which promise to double the return of a market index or double its inverse. At the same time, closed-end funds, many of which have used leverage for decades, were growing rapidly until 2007. Two Sides to Leverage While borrowing money can improve returns in good times, it also widens losses in bad times, and that is what happened in 2008. Some of these funds ended the year with even greater losses than the market as a whole. For instance, of the 15 mutual funds that apply the 130/30 strategy for U.S. stocks, only a third beat the Standard & Poor's 500-stock index in 2008, according to Morningstar Inc. Some of the laggards fell behind the index by five percentage points. "By definition, leverage can work for you and it can work against you," says Michael Sapir, chairman of ProFund Advisors LLC, the largest provider of leveraged index funds. His leveraged funds were among the worst- and best-performing stock funds last year. The tiny Mobile Telecommunications UltraSector ProFund fund, which aims to provide 150% of the daily returns of the Dow Jones U.S. Mobile Telecommunications Index, fell 90% last year. The fund has only $1 million in assets currently. Meanwhile, an exchange-traded fund that doubles down against semiconductor stocks, ProShares UltraShort Semiconductors, was the best performer last year with its 106% return, according to Lipper Inc. Even some traditional mutual funds that use leverage opportunistically have been hurt. The $1.5 billion Baron Partners Fund, which uses bank borrowing to increase its stock bets, fell 46.7% in 2008, nearly 10 points worse than the S&P 500's total return. Fund manager Ron Baron declined to comment. In a recent shareholder note, Mr. Baron said he believes that the companies his funds' invest in will "recover their value over the next several years." Of course, leverage has shaken up a lot more than the fund industry. Excess leverage on Wall Street is a big reason for last year's market meltdown. A number of hedge funds, which had borrowed heavily to turn a mound of equity into a mountain of assets, were forced to sell their positions to meet demands from creditors. This depressed various stock, bond and commodity markets. Under federal law, mutual funds can't take on debt of more than a third of their assets. If markets decline and assets fall, funds have to reduce their borrowing to stay within the limit. The $200 billion closed-end fund industry was forced to do just that last year, as markets fell sharply for two months after mid-September. Given these troubles, analysts don't expect all funds using leverage to survive. "There's going to be a move toward simplicity after this market downturn," says John Rekenthaler, vice president of research at Morningstar. He thinks the 130/30 funds are going to struggle to grow from here on. "It's a new type of fund, with fairly aggressive promises, complicated strategy, and they didn't perform well in the bear market," Mr. Rekenthaler says. " ... To me, that all spells investors and advisers saying, 'What's the point?' " How do 130/30 funds work? For every $100 invested, the fund will borrow stocks valued at $30 to sell "short" and invest this cash raised in the market, thus making the gross investment equal to $130. Paul Quinsee, who heads the team managing the largest 130/30 mutual fund, JPMorgan U.S. Large Cap Core Plus fund, expects the investing strategy to survive. His fund dropped about two points less than the S&P 500's total return last year, making it among the best performers amid such funds. Mr. Quinsee says the fund managers cut back on the amount of leverage in the fund, bringing it to less than 120/20. He declined to specify the funds' short positions but said his fund did what it's supposed to do. Some other 130/30 funds didn't fare as well. Funds that lagged behind the overall market included the Old Mutual Analytic U.S. Long/Short fund, the Dreyfus 130/30 Growth fund, RiverSource 120/20 Contrarian Equity Fund and the UBS U.S. Equity Alpha mutual fund. Scott Bondurant, co-manager of the UBS mutual fund, said his fund was hurt particularly after September, as panicked investors dumped some of the stocks owned by the fund to gravitate toward stocks of companies perceived to be safe during a recession. Currently, its strategy is down to 125/25. Managers of the other funds declined to comment. The biggest users of leverage are closed-end funds, versions of mutual funds that trade like a stock. About 72% of the 600-odd funds use leverage, according to Cecilia Gondor of Thomas Herzfeld Advisors Inc. They borrow money at lower, short-term rates and invest it in securities that they expect will earn them higher returns. Under Pressure However, this strategy came under pressure early last year, as their main route for borrowing, auction-rate securities, froze up. Since then, the closed-end funds have been paying higher rates on their borrowing. Later in the year, as net asset values declined, several funds had to deleverage or get rid of borrowing entirely to meet legal requirements. Closed-end funds are required by law to maintain $3 of assets for every $1 borrowed as debt, and $2 for every $1 issued as preferred shares. The Dreman/Claymore Dividend & Income Fund redeemed more than $300 million, or 71%, of its auction-rate preferred shares last year to stay in line with legal requirements. The Putnam Municipal Opportunities Trust fund had $394 million of leverage through auction-rate preferreds in early 2008, but in the fall its board announced its merger with an open-end fund to address the high cost of leverage. Since that announcement, the fund has eliminated leverage of at least $116 million.