Dabble in investing's daring side

By Tim Middleton

The failure of markets to rally in December is one more indication that the bear still holds control in its paws. By the same token, the failure of markets to plunge even further after a horrendous collapse Dec. 1 is one more indication Wall Street has run out of sellers, which should mean the next direction will be relentlessly upward.

Whether you're on the bearish or bullish side, you can double your bet, or even triple it, with the fund industry's nuclear weapons: leveraged and inverse exchange-traded funds.

These ETFs offer everyday investors simple ways to short the market and raise the stakes, and the growth of these funds tells me more of us are doing exactly that in this disappointing market.

The proceeds with leveraged funds can be huge -- but so can the losses if you bet on the wrong side.

Multiplying gains (or losses)

Here's how the math works: The Vanguard 500 Index Fund (VFINX), a straight index fund that tracks the market, was down 34% in 2008. UltraShort S&P500 ProShares (SDS, news, msgs), which bets against that market with leverage, was up 48.8%. Ultra S&P500 ProShares (SSO, news, msgs), the bullish alternative, was down 65.2%.

These funds are leveraged 200% against their targets; they go up or down twice as fast as the index they track. But you can buy even more leverage than that.

In recent weeks, Direxion has launched 14 ETFs with "3X" in their names, signifying triple leverage. Direxion Large Cap Bear 3X (BGZ, news, msgs) was down 30.1% in the most recent 30 days. Direxion Large Cap Bull 3X (BGU, news, msgs) was up 30.7%. The Vanguard 500 Index Fund rose 10.1% in the same period.

Note that none of these numbers is the mirror image of another, or of the index. Leverage does crazy things when daily performance is compounded over weeks and months. Usually it screws up the magnitude of gains or losses, but sometimes it screws up the direction, as well -- at times in December, both the Direxion bull and bear funds were down.

As I opined last week when I decided to utilize three leveraged ETFs in my MSN Money Model ETF Portfolio, I have confidence some of the two-times leveraged funds will work more or less as intended over periods as long as three months and probably longer. But as I'll explain here, they have to be monitored closely because if they begin to wander away from their goal, the damage can be extreme.

Keep that in mind if you decide to try your hand at leverage or shorting.

Derivatives for the rest of us

Your everyday exchange-traded fund is a very simple fund. It tracks a stock index minute by minute because it owns the stocks that make up the index. It cannot track the index perfectly because it has costs the index does not -- costs of trading and management. These costs drag down performance, but ETFs are cheap to run, and the best charge 0.2% or less in annual expenses. The typical equity mutual fund charges nearly 1.5%.

Leveraged and inverse ETFs, on the other hand, are not simple at all. The long versions often have a substantial portion of assets -- 85% or so -- invested in the stocks that constitute the index. But they also have to buy derivatives, more-complex financial instruments such as futures and options, to achieve their leverage. Short ETFs keep most of their assets in Treasury bills, because the derivatives they purchase are relatively cheap.

The granddaddy of ETF leveraging is ProShares, which has scores of portfolios labeled Short, UltraShort or Ultra. The first of these names signals an inverse strategy -- betting the market will go down. UltraShort adds leverage to deliver two times the inverse performance. Ultra designates a two-times leveraged long-only fund.

Rydex and Direxion offer much smaller families of competitors. Those from Rydex contain "2X" or "Inverse 2X" in their names, meaning they utilize the same degree of leverage as ProShares.

Among them, these three companies allow you to target the most popular asset classes, including sectors of stocks such as financials or technology. Nearly all are stock funds, but there are also Ultra Yen ProShares (YCL, news, msgs), UltraShort Lehman 20+ Treasury ProShares (TBT, news, msgs), UltraShort Lehman 7-10 Year Treasury ProShares (PST, news, msgs) and UltraShort Yen ProShares (YCS, news, msgs).

Continued: When ETFs go bad

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