How leveraged mutual funds can enhance diversification

The securities industry continues to fall over itself to introduce investments whose aim is to capture market share by offering greater portfolio diversification

The securities industry continues to fall over itself to introduce investments whose aim is to capture market share by offering greater portfolio diversification.

While no one argues against portfolio allocation as the key to successful investing, this explosive product trend brings as much redundancy as novelty to the continuing portfolio optimization process.

Among the dozens of new means of enhancing risk-adjusted performance through expanding market sector exposure, there are several fund vehicles that present an opportunity for tactically managing portfolio risk to enhance risk-adjusted returns.

The advent of leveraged mutual funds has leveled the playing field for retail-investment managers, who until recently have had few means of serving their clients. Increasingly popular thanks to the huge growth of the hedge fund industry but spurned by the Securities Exchange Commission as inappropriate for their investors of more modest means, the often highly profitable alternative-investment funds have been kept largely off limits to retail investors.

While it is the commonly outsized risk of hedge funds that is the stated concern of the SEC for less wealthy investors, it does at times appear that the rich are simply getting richer.

We intend to show how the disciplined use of leveraged mutual funds can result in a further expansion of portfolio diversification. While achieving a better-performing portfolio over time is its goal, this article isn’t to be construed as specific investment advice.

Figure 1 shows a fairly recognizable example of a diversified portfolio whose effort is to maintain an overall 60-40 equity/fixed-income blend.

Leveraged mutual funds’ primary investment targets are to match 125%, 150% and in some cases 200% of the return of an investment industry benchmark. These include, but are not limited to, the Standard & Poor’s 500 stock index, the Nasdaq Composite Index and Russell indexes; some funds track the performance of U.S. Treasury securities.

Among the better-known fund companies that offer these funds are Boston-based Direxion Funds, ProFund Advisors LLC of Bethesda, Md., and Rydex Investments of Rockville, Md. The funds engage chiefly in financial-index futures and options contracts to maintain their predetermined degree of leverage but also may engage in equity swap agreements to accomplish their management aim.

A thorough reading of fund prospectuses is important when considering any fund investment. Even within our theoretical portfolio, there is likely some room for additional sector diversification.

But re-balancing it with leveraged mutual funds (Figure 2) shows how much additional capacity is freed up to disperse assets better across investment sector or class.

The account has achieved an equivalent market risk exposure as before but now is left with 32% of assets unallocated. The traditional 60-40 investment balance between equities and fixed-income investments has in some measure been maintained.

The real challenge remains discerning what the consequences of this freedom are for each individual account allocation, as such an allocation must reflect the predetermined risk tolerance of the portfolio’s owner.

The possibilities abound and include the following:

The highly risk averse may leave the remaining funds in a riskless money market product or seek out very negatively correlated fund candidates for investment.

The disciples of diversification may seek ever more ways of simply neutralizing their exposure to market risk: Commodity, emerging-markets and currency funds are currently popular.

The more tactical minded may dollar cost average the excess capital into existing or additional sectors, thereby smoothing their in-crease to market exposure over time. This fairly common account procedure systemizes the equal investment of capital from one fund to another, usually on a monthly or quarterly basis.

Let’s take one last look at our theoretical portfolio, now with a more robust combination of disparate fund holdings:

In Figure 3, we have employed additional leveraged and non-leveraged mutual funds to di-versify the account allocation better over both investment class and fund sector. The account now has exposure to commodities, real estate and a market-neutral strategy now available via a mutual fund holding.

The international-equity exposure is now diversified across two different tiers of investment quality (developed and emerging international equity). Along with this additional diversification (and exposure), however, is a holding of risk-free money market funds for either future investment interests or current liquidity needs.

Portfolio allocation remains the chief determinant in achieving successful investment performance. However a portfolio is positioned to serve unique investment risk tolerances, return goals or diversification interests, the tactical investment strategy of using leveraged mutual fund products represents a fresh approach to the entire exercise of investing.

The nature of any financial leverage demands greater attention to continuing portfolio re-balancing, but the increased work may be well worth the effort.

Mark Kruse is principal of Brackenwood Capital Management LLC, a Seattle-based registered investment advisory firm.