TRADING TECHNIQUES
Designer Funds
by Gary H. Elsner, Ph.D.
Mutual funds show a less than stellar performance relative to the Standard & Poor's 500 index. It should come as no surprise, then, that Wall Street has responded by offering products that mimic the S&P 500. Going a step further, some funds are set to do the exact opposite of the S&P 500 and thereby offer a hedge. Here are some guidelines.
The right financial instruments are the keys to great investing. Over the last four years, 90% of mutual fund managers have been outperformed by S&P 500 index funds, so it is no surprise that new funds created to outperform the S&P 500 have attracted attention. I refer to these as designer funds because they are designed to perform in specific ways, as opposed to having the simple objective of maximizing returns.
FIGURE 1: BETA TO THE S&P 500. Figures 1 and 2 show the designer funds provided by Rydex, ProFunds, and Potomac Funds, and display each fund's degree of leveraging. Figure 1 shows the funds that leverage the S&P 500 index.
As an example, the Rydex Nova fund is designed to have 150% of the movement of the S&P 500. If the S&P 500 goes up 6%, Rydex Nova will go up approximately 9%. If the S&P 500 goes down 6%, then Rydex Nova will go down about 9%. Not only that, recently introduced funds are designed to have movements of up to 200% of the S&P 500. And there are funds that move in an inverse relationship to the S&P 500 and the NASDAQ 100 as well.
If we refer to these enhanced movements as leveraging, we can create just about any degree of leveraging by investing different amounts in one of these instruments and in a money market fund. Let's take a look at the new designer funds, study how we can achieve various degrees of leveraging, and determine ways in which these funds can be used in developing new investment models.
THE NEW DESIGNER FUNDS
Let's look at the concept of beta. Beta is basically the amount of movement of a fund relative to an index or another fund. Often, the base of comparison is the S&P 500 or another broad market index, but it could be anything, including a fund or an index such as the NASDAQ 100. So if a fund were to move 150% more than, say, the S&P 500, it would have a beta of 1.5. If it were to move 200% of the S&P 500, it would have a beta of 2.0. Funds are often compared on their level of beta, because the higher the beta, the higher the volatility and, thus, the higher the downside risk. On the other hand, a fund with a high beta also has a high degree of expected upside movement.
The Rydex Corp. was the first to introduce these designer funds, starting in 1993 with Nova and Ursa. (The company has since added more.) The demand for these funds turned out to be high, and by 1996, Rydex had more than $1 billion invested. (As of year-end 1998, Rydex had more than $2 billion invested.) In 1997, two more companies, ProFunds and Potomac Funds, started providing designer funds.
Figures 1 and 2 show the designer funds provided by Rydex, ProFunds, and Potomac Funds, and display each fund's degree of leveraging. Figure 1 shows the funds that leverage the S&P 500 index and Figure 2 shows the funds that leverage the NASDAQ 100 index.