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Tim Middleton

Mutual Funds12/30/2008 12:01 AM ET

Gain some leverage with ETFs

Want to get ahead of possible market improvements in the first quarter of 2009? Leveraged ETFs are a handy, if somewhat risky, way to jump on today's low stock and bond prices.

By Tim Middleton
MSN Money

It's time for investors to get aggressive if we want to get back what we've lost.

My model portfolio of exchange-traded funds took a pasting in the fourth quarter along with the entire market. A surge of panic selling in October and November fueled the losses, most of it due to massive redemption at hedge funds. (When investors demand money back from those funds, they have to sell investments to raise cash.)

The result left my model ETF portfolio little changed from where it began five years ago.

The future will be better, I'm sure. Bear markets combined with deep recessions are terrifying, discouraging things, but over the centuries we've survived them all, and we'll survive this round, too.

Stock prices are way down, of course. And another result of the carnage has been to drive the prices of what the bond market calls "credit products" to fire-sale levels. The label distinguishes stuff such as corporate and mortgage bonds from Treasurys, which have no credit risk.

That makes both stock and bond prices compelling right now. Ergo, I want to own a ton of both. And thanks to leveraged ETFs, I can.

Applying leverage

Not unlike a hedge fund borrowing on margin, an ETF portfolio can leverage its exposure to more than 100% of assets. An ETF that tracks the Standard & Poor's 500 Index ($INX), for example, can use leverage to make sure the fund gains 20% whenever the index rises 10%.

In short, leveraging provides more bang for the same investing buck.

Specifically, I'm leveraging 22.5% of the portfolio so we can overweight both equities and fixed-income securities. I think that, at worst, the market will go sideways in the first quarter, benefiting the bonds. At the best, it will rise, and possibly sharply. That would benefit the credit products as well as the stocks.

I've written about leveraged ETFs in the past, and I am generally skeptical of them because they can misbehave. The big risk is that while leveraged funds go up faster than the indexes they track, they also go down faster during a decline.

But if we had used the leveraged funds I recommend here in the most recent quarter, we would have ended up better off, and that's when they were under maximum stress. I'm willing to accept the risk they bring to the table.

Wringing out the risk

The portfolio tumbled 24.5% in the past three months, as of Dec. 22, bringing it to $103,296. Only the Vanguard Total Bond Market ETF (BND) and cash delivered positive returns, of 3.9% and 0.3%, respectively. All of the other positions were down 28% or more.

Interest and dividends of more than $500 took the portfolio's cash hoard to $16,035, or 15.5% of assets.

Struggling through the worst quarter of the worst bear market of my lifetime wasn't pleasant, but at least it has wrung lots more risk out of stocks. I think we are presented with a buying opportunity, so I want to raise the portfolio's equity exposure. But I also want a boatload of credit products.

Video on MSN Money

Market volatility © Kyu Oh/Getty Images
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Mike O'Rourke of BTIG Bass Trading, Scott Burns of Morningstar and CNBC's Maria Bartiromo discuss whether leveraged ETFs are creating volatility.

So I'm replacing domestic equity ETFs with leveraged ETFs. The replacements cost roughly half as much as the funds they replace, and I'll put that extra cash into bonds. The effect of my actions will be to create a portfolio that has 70% exposure to equities, 40.8% to fixed income and 11.7% to alternative asset classes, namely energy and commercial real estate.

If I had done this at the end of the third quarter, buying exactly as many leveraged ETFs as were needed to capture the same equity exposure we actually had at that time, and then put the balance of the proceeds from the sale of the equity ETFs into Vanguard Total Bond Market, the portfolio would have been worth $105,442 now -- an advantage of more than $2,000.

That's because the leveraged ETFs performed as advertised in the fourth quarter. Plus we would have earned hefty dividends on the bonds, as well as a nice capital gain. In short, what actually happened is what should have happened. This gives me confidence we can use this tactic to our benefit in the three months to come.

Continued: The buys and sells

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