Does your portfolio have significant exposure to leverage—without you even knowing about it? If you own mutual funds, the answer could be yes.
Mutual funds can legally borrow up to 33.3% of the value of their assets. Some newer types of funds take full advantage of this limit as a central part of their strategy. These include 130/30 funds, which borrow money to short some stocks and then bet long on others, all with the goal of beating market returns. There are also “leveraged index” funds, which aim to double the daily return of a given market index using borrowing and derivatives. However, even managers of more traditional types of funds often use leverage opportunistically to goose returns when times are good.
In recent years, the use of leverage and derivatives in mutual funds has been increasing significantly. Right now there are over 7,700 mutual funds in the U.S., managing over $15 trillion in assets under management, which is roughly the size of the entire U.S. G.D.P. The potential economic exposure to leverage is enormous.
The real problem with leverage is that while it can boost returns in good times, it also worsens losses when things go south. After the financial crisis in 2008, many leveraged funds lost more than the market as a whole—sometimes much more. That can trigger a cascading effect. When a fund’s total asset value declines, its borrowings may now account for more than the legally-allowed 33.3%. The fund has to deleverage quickly, possibly forcing the portfolio manager to sell assets fast at fire-sale prices to pay off debt. Investors have to either get out with the crowd or take the hit.
Quite frankly, you need to know what you own. You could have more exposure to leverage than you realize. The good news is, many funds that could technically use margin do not, because they follow a conservative investment philosophy and focus on avoiding permanent loss of capital. Finding these conservative picks requires qualitative due diligence. You cannot rely on the fund name or the Morningstar grid alone. You need to read the prospectus closely, and then hire the right team to do the heavy lifting for you—including annual onsite due diligence visits and quarterly monitoring of a fund’s underlying holdings to uncover hidden pockets of risk.