Mutual funds can put a certain amount of leverage to work for better results even though, traditionally, they have not been considered leveraged financial products.

In fact, products have emerged that seek to reap the benefits of leveraged hedge funds in mutual fund packages.

However, liquidity requirements govern all mutual funds with strict rules regarding the degree of leverage a mutual fund may use.

Nevertheless, the promise of accelerated earnings made possible by the use of debt to increase a fund’s position has drawn many investors to leveraged mutual funds.

What Is Leverage?

In its simplest form, leverage is debt. When a company uses leverage, it means it takes on debt to achieve a goal faster than it is able to with equity capital alone.

In investing, to use leverage means to borrow funds to buy additional securities to reap a greater gain than is otherwise possible.

How It Works

Leveraged investments use debt to increase their gains in a short period. By increasing the amount of money invested, they increase their potential profits.

Conversely, they are liable to creditors if investments fail. For this reason leverage is inherently very risky. However, as investors know, risk and volatility provide the opportunity for huge gains (or crushing losses).

How Do Leveraged Mutual Funds Work?

Mutual funds are strictly limited by the U.S. Securities and Exchange Commission with regard to the percentage of their portfolios that can be funded by borrowed money.

This is because mutual funds are, by definition, highly liquid and the greater the proportion of debt to equity used in a fund’s portfolio, the less liquid the fund becomes.

Hedge funds are well known for using huge amounts of leverage to take advantage of highly illiquid investment opportunities that require large amounts of capital and patience. Mutual funds are meant to be bought and sold easily and remain affordable for a wide range of investors.

Leveraged mutual funds, therefore, seek to split the difference between these two asset classes by using a smaller amount of leverage while employing less traditional tactics, such as shorting and arbitrage strategies.

Allowed Percentage of Leverage

By law, the maximum amount of leverage that an open-end mutual fund can have is 33.33% of its portfolio value. If the portfolio is valued at $1 million, it may borrow up to $333,333 to increase its buying capacity.

However, if assets in its portfolio fair poorly and the fund loses value, then it must reduce its leverage to remain within the required limits.

What Kinds of Mutual Funds Use Leverage?

Most leveraged mutual funds fall into the leveraged index fund category. This simply means that they attempt to return a certain multiple of the returns generated by an index. For example, a 2X S&P 500 fund is specifically managed to return twice the returns generated by the S&P 500.

Conversely, some leveraged funds, called inverse funds, attempt to return an inverse multiple of an index’s returns.

If a fund manager believes the S&P 500 will lose value in the coming year, for example, their fund may be aimed at generating a profit that is twice the amount of the index’s loss. A 10% drop for the S&P means a 20% profit for shareholders if everything goes to plan.

Other leveraged mutual funds employ a 130/30 strategy, where they borrow $30 for each $100 of portfolio value and use it to short some stocks while going long on others to beat a given benchmark. Other funds are less aggressive, employing a 120/20 strategy instead.

The Bottom Line

Mutual funds, although designed to be a liquid investment, are allowed by the Investment Company Act of 1940 to use leverage (or borrowed funds) to potentially enhance their returns.

However, the amount that they may use is strictly limited due to the risk of leverage to amplify losses and the need mutual funds have to make redemptions.