Leveraged "Index" Funds - A Good Idea?

A colleague recently told me about ProShares Ultra S&P500 (AMEX: SSO). The goal of this investment vehicle is to provide investors with double the return of the S&P500 on any given day. When the S&P goes up 1% SSO is supposed to go up 2%. On days when the index drops 1%, SSO should decline by 2%.

This is an interesting concept for long term investors. Based on historical returns, the S&P can be expected to yield about 8% per year. If you believe that this trend will continue an investment in SSO or in something similar could potentially yield much higher returns.

To be precise, assuming an upwards trend of the S&P, SSO would yield more than double the return of the index due to compounding. Or at least, that's the theory, if you believe it. Here is an example: assume you invest $10K in the S&P. On day one the market goes up 1% and the market repeats this performance on the second day. At the end of day 2, you would have $10201. Assuming SSO works as billed, the first day it would go up 2% and the same performance would repeat on day 2. At the end of the second day you would have $10404. So, by investing in the S&P you gained $201, while by investing in this new vehicle you would be gaining $404. Notice that SSO gained more than double the S&P gain due to compounding. Unfortunately, the same is also true on the downside - if the market tanks, your investment will plummet like a rock.

A number of questions come to mind. First, is SSO real? Can it deliver volatility that is equal to 2X that of the S&P? This chart comparing SSO to the S&P for the past year shows that SSO clearly has more volatility. I could not easily find the beta value for SSO. Second, what does this investment vehicle cost? The prospectus (see page 8) describes an annual expense ratio of 1.5%. Pretty darn steep for an index investor like myself. The third question is how can SSO do what it claims it can do? The answer is: by using leveraged, aggressive investment vehicles. It uses futures contracts, options and a variety of other straetgies to achieve its objective. Could such strategies deliver the promissed results? Possibly.

So, what's the bottom line? Such investment vehicles are not for me. While the concept is very interesting, and could work in principal, I am going to stay out of this one. My three main reasons are: 1. This vehicle is still unproven from my perspective; 2. If you happen to start investing at a time when the market is about to decline, even modestly, you can basically kiss your assets goodbye; 3. By investing in something like SSO you are taking on MUCH more risk, for supposedly higher returns. My tolerance for risk is not THAT high, so I am going to sit this one out.

Still, I will be monitoring this asset class and will talk to my colleague to see how his investment is doing over the longhaul. For now, it's simple, boring index funds for Shadox.