THESE FUNDS SIZZLE, BUT NEW INVESTORS MAY NOT BE PREPARED FOR HEAT: THE DERIVATIVES THAT FUEL RETURNS COULD SCALD

Some new names are topping the mutual fund performance lists, and they’re not of the household variety.

Last year’s top three aggressive equity funds didn’t come from the likes of Fidelity Investments or Janus. They were managed by fund groups catering to market-timing advisers.

The numbers are eye-popping by any definition. The ProFunds UltraOTC Fund returned 185% last year, while the Potomac OTC Plus Fund delivered 104% and the Rydex OTC Fund 87%. These were the three best-performing funds in Lipper Inc.’s capital appreciation category, which tracks aggressive stock funds.

Not surprisingly, following the unalterable rule that cash flows follow performance, individual investors now are piling in to these funds and similar ones at the three companies – which estimate they’ve taken in at least $1 billion in retail money in the last year despite their obscurity and dependence on derivatives to fuel performance.

The question now is whether those investors know what kind of risk they’re taking, since these funds were launched specifically for advisers who dart in and out of the market based on technical indicators.

We’ll find out when the next correction hits.

All three funds are indexed to the Nasdaq 100 and are leveraged upward to varying degrees in order to provide extra kick to the normal returns of the index. Because the Nasdaq 100 – dominated by big technology firms whose stocks soared – had such a great year, returning 85.48%, the funds’ added return came from the leverage.

The fund firms also offer products that similarly juice up returns for the Standard & Poor’s 500 stock index. In addition, for bearish times, they have funds that offer leveraged short positions on the indexes, and money-market funds for when timers want out of the stock market altogether.

For timers, the funds are great. If these advisers’ technical indicators are bullish, they’ll often want to buy a fund that promises returns greater

than the index it’s designed to mimic; when their black boxes turn bearish, there’s the short funds.

The most leveraged of these funds – ProFunds UltraOTC – offers a beta, or risk factor, of 2.0, which means the fund’s returns will double the Nasdaq 100’s when the index is gaining. Of course, if a investor bets wrong, losses also will be twice the index’s.

Leverage – achieved by buying options and futures on the indexes – is a powerful thing, both for good and for ill. And less sophisticated investors may have no idea what the ill effects could do to their portfolios.

“Where do you draw the line?” says Don Phillips, president of Chicago fund rating firm Morningstar Inc. “It’s sort of like prescription drugs being sold over the counter. The question is, might they get into the wrong hands?”

Hard numbers aren’t available, but the three fund companies catering to market timers all report an influx of assets from individuals.

The biggest, Rockville, Md.-based Rydex, estimates that about 30% of its $4 billion under management is retail money. That’s up from about 20% just last May, when Rydex controlled $2.6 billion, says Skip Viragh, Rydex president.

The story is the same for Rydex’s smaller competitors. Individuals account for roughly 40% of the $700 million managed by Bethesda, Md.-based ProFunds, and 15% to 20% at Potomac Funds in Alexandria, Va., which runs $175 million.

“We have a lot of retail money – frankly, more than we thought we would have,” says Louis M. Mayberg, president and co-founder of ProFunds Advisors LLC, which was begun little more than a year ago. “We have been very surprised as to how much long-term, buy-and-hold money we have.”

Executives at all three firms acknowledge their funds may not be appropriate for neophyte investors, but they believe that their relatively high investment minimums keep out people who can’t take the risk.

“Of all the three fund complexes, we have the highest minimum,” says Mr. Viragh of Rydex, which demands at least $25,000 to invest, both for taxable investors and those using individual retirement accounts. “That has a way of screening out the unsophisticated investor.”

ProFunds has a $15,000 minimum; Potomac’s is $10,000.

None of the fund groups specifically targets individuals, although Potomac Funds are available for no transaction fee on the mutual fund supermarkets (the other two are on the supermarts for a fee). Yet individuals are finding the funds, apparently because they regularly are atop published performance lists (see States on Page 16).

“It shouldn’t be the first investment someone makes the first time they go into mutual funds,” says Tim Hagan, chief financial officer for Potomac Funds. “It really calls for the type of investor who’s been around. We’ve had calls from people who literally don’t understand anything about the stock market, and we’ve kind of gently told them, `Maybe you shouldn’t be in this fund.’ These people just look at performance, that’s all.”

Still, the concept of index funds that are leveraged to boost returns can suit buy-and-hold investors who feel the long-term trend for stocks is up and are disciplined enough to sit tight during market dips.

“If they stick to a strategy of long-term investing, these funds will do well for them,” says Terry Bommer, vice president of Financial Timing Services Inc., a Chesterfield, Mo., market timing advisory firm with $120 million under management. “But my experience has been that some people who say they are long-term investors get scared when the market goes down significantly.”