What are Leveraged Funds and How it Works?

Leverage funds are financial instruments that borrow capital to increase the return on investment. They promote extremely higher returns than other funds through leverage, which is mostly borrowed or derived from the underlying assets, thus increasing exposure to them.

Commonly, leveraged funds promise larger returns when the market is favourable for investing, but they also carry a high level of risk as the losses are equally magnified. In this article, we will look at these leveraged funds, how they work, and the possible benefits and risks of using them in investment strategies.

Leverage funds are mutual funds that use financially leveraged investment techniques to maximize returns. They amplify returns by using leverage, typically aiming for a multiple of the performance of the underlying index or asset.

These techniques include trading, buying assets on margin, short selling, and others. Leveraged funds provide multiples of the index or benchmark that they track.

These funds typically utilize derivatives like options, futures, and swaps to amplify the performance. Below is a brief discussion of how they work.

Leveraged funds function through standard brokerage accounts, using margin. Investors borrow money from brokerages to purchase stocks to make higher gains. In simple words, you buy a larger portion in much smaller capital.

Below is an illustration to understand it clearly:

Your Investment: ₹50,000

Leverage: 2x (which means you borrow an additional ₹50,000 from your broker, so your total investment is ₹100,000)

Scenario 1: Fund Value Increases by 10%

Your total investment is ₹100,000

A 10% gain on ₹100,000 = ₹10,000

After the gain, your total value is ₹100,000 + ₹10,000 = ₹110,000

You repay the ₹50,000 you borrowed, leaving you with ₹110,000 - ₹50,000 = ₹60,000

Profit: ₹60,000 - ₹50,000 = ₹10,000, which is a 20% return** on your initial ₹50,000

Scenario 2: Fund Value Decreases by 10%

Your total investment is ₹100,000

A 10% loss on ₹100,000 = ₹10,000

After the loss, your total value is ₹100,000 - ₹10,000 = ₹90,000

You still owe the ₹50,000 you borrowed, so you have ₹90,000 - ₹50,000 = ₹40,000

Loss: ₹50,000 - ₹40,000 = ₹10,000, which is a 20% loss on your initial ₹50,000

Some risks and drawbacks of leveraged funds are stated below:

• These funds do not exactly reflect the daily returns of the index they follow in the long run.
• The expanded daily returns may provoke abrupt losses in the short term. It may also result in a loss of the funds' value.
• Certain leveraged funds are not likely to trade copiously, which restricts your capacity to sell or buy.
• As they use derivatives to amplify returns, these funds do not track the underlying benchmark carefully.

Investors must keep in mind their tolerance of risk before opting to invest in leveraged funds. Additionally, they must consider the higher expense ratio, their investment horizon, and other factors that may influence their investment strategy. Lastly, it is crucial to acquire proper market experience before investing in such leveraged funds.

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