More Leverage Risks in Mutual Funds

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More Leverage Risks

Earlier in our discussions about risk, we looked at what leverage risk could do to your mutual funds. The idea of borrowing to buy stocks is nothing new. Federal laws are in place to prevent funds from borrowing more than 30% of their total assets. When they leverage, mutual fund managers attempt to buy additional shares with borrowed money for the fund to increase returns and if the stocks do well, sell for a profit.

But when stocks do poorly, the results can hurt a fund worse than if they hadn't borrowed a dime. The reason is fairly straightforward: you also have to pay back what you borrowed and as the value of the stocks go down these funds often sell well below the purchase price. For individual investors, this is referred to as a margin call. For mutual fund managers, this is referred to as a disaster, a perfect storm. To the overall markets, the effect can be amplified, forcing the sale of stocks that might have been held onto until the markets recover.

Much of the current depressed value of stocks, bonds and commodities was due to this type of activity. It was, in all fairness, exacerbated by the hedge fund industry. These mostly unregulated funds borrow in much larger quantities that their regulated brethren. Hedge funds, selling to satisfy creditors has kept the activity and the recovery on hold.

That said, could this be a return to simplicity, a time when things were more clear and transparent? Possibly but it will be only until investors begin to forget the lessons we should have learned.

Many of the recently created 130/30 funds took some of the hardest hits in the recent downturn. Investors might take another look at the strategy, which works like this: When a fund has $100 invested, the manager borrows $30 worth of stock (called shorting, where possession never really takes place and the manager buys at a price hoping the stock goes down so the difference between the sale price and the purchase price create a profit) which essentially creates a $130 worth of stick where only a $100 was actually used.

If you happen to be in a closed-end fund, you are most likely holding a fund that has engaged in this kind of leveraging but has had to deleverage once the credit markets froze and as they thaw, become more expensive. To continue to borrow, these funds are now forced to pay a higher rate for the action. Closed-end funds are also subject to the federal law and unlike other types of funds, trade like stock.

What do you do if your closed-end fund takes (or has already taken) a much harder hit than comparable open-end or no-load funds? If the fund family is large, you can look for mergers with funds within the family that have little or no leverage exposure. The merger in essence, satisfies the law and gives the fund a renewed asset base to begin the process all over again. Another idea, rethink your fund choices an opt of the no-load, lowest fee fund possible. The switch could can you several percentage points in returns.

Next up: sector risks