BUSINESSWEEK ONLINE : JULY 31, 2000 ISSUE
BUSINESSWEEK INVESTOR Like Risk? Have We Got a Fund for You Leveraged sector funds magnify the action Your Internet fund isn't volatile enough for you? Biotech puts you to sleep? Here's an adrenaline shot: leveraged sector funds. Last month, ProFunds Advisors in Bethesda, Md., launched 17 juiced-up index funds. Called UltraSector funds, they use options and other leveraging tricks to magnify the action in 17 different Dow Jones sector indexes. These funds will give you a real roller-coaster ride. Their aim is to achieve 1.5 times the indexes' ups or downs on a given day. So if the Dow Jones Internet Index, say, rises 10%, ProFunds UltraSector Internet Fund should leap 15%. If the index falls 10%, the fund ought to drop 15%. That makes the UltraSector funds extremely risky and unpredictable for ordinary index investors, who normally want to keep risks in line with the overall market. But these funds, which are no load, could be just the ticket for traders who like to dart in and out of hot groups. ACTION-PACKED. In fact, ProFunds is very accommodating to speculators, allowing unlimited trading without redemption fees--and, if you buy shares from the management company directly, no transaction fees. ''What I like about ProFunds is that I can have a portfolio as large as I want and trade as often as I want,'' says William Donoghue, an investment adviser in Milford, Mass., who trades sector funds. ''Fidelity is not going to let me do that.'' Not only do Fidelity's sector funds have a 3% front-end load, they also hit overactive traders with redemption fees. UltraSector funds are also a cheaper and safer way to leverage than buying shares on margin. Interest rates on margin loans are currently 8% or higher, and investors can go deep into debt if their margined positions decline sharply. By contrast, expense ratios for UltraSector funds run 1.35% a year. That's high for an index fund--about seven times what Vanguard charges on its index funds, for example--but not for an actively managed sector fund. And unlike margin investors, ProFunds investors can't lose more than what they put in the funds. So far, ProFunds has been hitting its daily target of 1.5 leverage fairly consistently. But an UltraSector investor should be wary: The 1.5 applies only to a single trading session. If the index keeps rising (or falling) day after day, the kick from the leverage compounds. For instance, the Dow's energy index has slipped 5.3% since June 19, the day ProFunds launched most of its new funds. But its leveraged energy fund has lost 9.4%--or 1.75 times the index. So the 1.5 target leverage is a bit misleading. ''You cannot pick two points in time--January 15th and May 3rd--and say 'because the index is up 10%, I expect the fund to be up 15%,''' concedes ProFunds President Michael Sapir. ''It doesn't work that way. The funds get one-and-a-half times the daily return of their benchmarks.'' The final return, he says, is based on ''wherever the compounding leads you.'' Leveraging index funds is nothing new. Rydex Funds in Rockville, Md. launched the first leveraged index fund in 1993--Rydex Nova, designed to amplify the Standard & Poor's 500-stock index' moves by 1.5 times. Nova was so successful that Sapir, who was Rydex' legal counsel at the time, decided to team up with investment banker Louis Mayberg and start ProFunds in 1997. To manage the leveraging, they recruited William Seale, a professor of finance at George Washington University, who had been a commissioner during the Reagan Administration at the U.S. Commodity Futures Trading Commission. Their first funds sought to surpass Rydex by doubling the moves of the S&P 500 and the Nasdaq 100. The Nasdaq fund, ProFunds UltraOTC, was a spectacular hit. Since its inception in December, 1997, it has soared 649.4%, while the Nasdaq index has climbed 274.4%--a good example of the compounding effect. UltraOTC is now the firm's largest fund, with $1.5 billion in assets. What's new is leveraging sector indexes. Potomac Funds in Alexandria, Va., launched the first last December--Potomac Internet Plus, which leverages the Dow Jones Internet Index by 1.25 times. But ProFunds really upped the ante with its 17 funds--plus four more in registration. Most popular of the UltraSector funds so far are those for biotech and, perhaps surprisingly, real estate, a terrible performer until recently, but one that is uncorrelated with other sectors. ''[Many] people believe in adding uncorrelated assets to their portfolios to increase returns and reduce risk,'' says Sapir. Least popular are six funds that haven't been able to attract any money yet, including funds for precious metals and for consumer products such as beer, tobacco, and cosmetics. How does the leveraging work? Portfolio manager Seale won't disclose his ''secret sauce.'' But he typically invests 75% to 80% of a fund's assets in the stocks of the particular Dow sector index. The remainder goes into buying on margin or into options or swaps. SAVVY SWAPS. Call options, which give the buyer the right to buy shares at a specific price at a future date, can be purchased for a fraction of the cost of buying shares outright. That allows the fund to magnify any gains in the stock. Publicly traded options are not yet available on Dow Jones sector indexes, however, so Seale has to buy options on each stock in an index--a laborious process. For that reason, he has been leaning heavily on swaps, which he buys from broker dealers and money-center banks. Swaps are agreements to exchange income streams on securities--and since they're between private parties, the agreements can be customized for almost any purpose. In these swaps, Seale's broker dealer agrees to pay whatever gains occur on a portfolio of shares representing, say, the Dow Jones Semiconductor Index. Seale, in turn, agrees to pay any portfolio losses, plus a fixed interest rate on the dollar amount of the swap. ''We give them a fixed income stream, and they give us a variable one,'' Seale says. These swaps are done with little or no collateral, so Seale can get the return on $25 million in the semiconductor index without actually having the $25 million. All he has to do is pay the interest on the money--and any losses on the shares' market value. Are such tricky maneuvers dangerous? Of course. These funds are not for the faint of heart. Adding to the risks is that unlike traditional index funds, which are broadly diversified, sector funds can be highly concentrated. In the case of five of the Dow Jones indexes--biotechnology, energy, precious metals, semiconductors, and wireless communications--just three stocks account for over 50% of the weighting. UltraSector Semiconductor, for instance, has more than 38% of its assets in one stock: Intel. Anyone expecting a normal index fund--forget it. These are funds for volatility junkies. By LEWIS BRAHAM _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP					RELATED ITEMS Like Risk? Have We Got a Fund for You TABLE: Peaks and Valleys INTERACT E-Mail to Business Week Online

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