Should You Consider Using Leveraged and Inverse Funds in Your Portfolio?

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Building the right investment portfolio is a dynamic process. There’s no perfect solution that fits every investor’s needs, and even a well-designed portfolio will need adjusting on a regular basis in order to minimize risk and maximize profits. At some point, one might even consider adding in leverage to boost profits and take advantage of certain opportunities.

Using leverage in your portfolio can be a great way to boost overall returns if you have the risk tolerance to deal with higher volatility. But making the choice to add these types of funds to your portfolio shouldn’t be taken lightly. There’s a significant impact that it can have on your overall investment goals. There’s also a significant difference in the behavior of a traditional portfolio and one that includes leveraged and inverse funds that could mean changes to your investment strategy.

Using leverage in your portfolio

A leveraged or inverse fund is an ETF or mutual fund that uses leverage or short positions in its trading portfolio. Leveraged funds use margin accounts and futures contracts to generate an amplification of 2-3x what the benchmark index produces. In other words, if an index rises 1%, a leveraged fund might rise 2% or 3%. However, it also means losses are just as amplified, generating losses that may be too much for more conservative investors to withstand.

Inverse funds work on much of the same principles as leveraged funds but are designed for short positions. If an index falls, an inverse fund will profit and vice versa. Unlike pure leveraged funds, inverse funds are meant to be temporary and not long-term holdings. Investors can use inverse funds to hedge their portfolio against downside risk, but since markets tend to rise over time rather than fall, holding on to an inverse fund over a long period of time will likely result in losses.

Leveraged funds can also be used temporarily to take advantage of new opportunities. For example, if you believe that the technology sector will outperform other sectors over the next year, you may consider adding a leveraged technology fund to your portfolio for the next 12 months. Used sparingly, leveraged and inverse funds can greatly boost portfolio returns while reducing the level of risk normally associated with them.

Final considerations

Investors should take extra caution when adding a leveraged or inverse fund to their portfolio. Unless investors can identify a real need for such a fund, they may want to consider more traditional alternatives. Inverse funds, in particular, should only be used in select circumstances. They require active management to know when to buy and when to sell to avoid unnecessary losses. Investors who understand due diligence may find that leveraged and inverse funds have a role to play in their portfolio, but investors who don’t have the time to commit to their investments should avoid using them.