Leveraged mutual funds are just like regular mutual funds, but use leverage to increase their returns, delivering multiples of the index or benchmark they track. Leverage allows an investor to magnify their returns, shortening the time it takes to achieve a desired return. Whatever their reasons for doing so, these investors take on additional risk in order to make more profit. The funds are often labeled “ultra,” “bull” or “2X” and some use derivatives such as options, futures and swaps to boost performance.

The way leverage works is by using margin in a standard brokerage account. Most brokers allow investors to borrow money from them to buy more stocks. For example, if an investor owns $20,000 worth of a mutual fund, they could borrow $20,000, doubling their exposure without the use of their own money. If the mutual fund rises in value, the profit would be twice as much as it would be without it.

The caveat, however, is that if the mutual fund falls, the investor will lose twice as much money, in addition to paying interest on the loan. That being said, for the more risk-tolerant investor, leveraged mutual funds offer more exposure on an otherwise traditional investment.

Be sure to also read the 7 Questions to Ask When Buying a Mutual Fund

Leveraged mutual funds can be a great addition to any portfolio. They give an investor additional exposure, while being a part of an active trading or asset allocation strategy. Due to these characteristics, leveraged mutual funds typically have higher operating expenses as a percentage of assets compared to other funds, with a total management expense ratio of typically 3% to 5% per year compared to 1.3% to 1.5% for a non-leveraged mutual fund.

Just as with traditional mutual funds, there are many different types of leveraged mutual funds and they generally cover the same types. Again, using the moniker “ultra,” “bull” and “2X” investors can distinguish them. By nature, they are actively managed with frequent rebalancing with higher management expense ratios. The types can be broken down into:

• Index Funds
  Index funds invest in equities or fixed income securities that follow a specific index such as the S&P 500 or NASDAQ-100.

• Money Market Funds
  These funds mostly invest in a combination of government securities, such as Treasury Bills.

• Bond Funds
  Bond funds are anything fixed income, and can consist of treasury bills, debentures, mortgages and bonds.

• Equity Funds
  Equity funds are broken down into the major sectors of the S&P 500, namely: consumer, healthcare, financials, industrials, information technology, telecommunications, utilities and materials.

• Balanced Funds
  As the name suggests, balanced funds invest in a variety of equities and bond securities.

• Specialty Funds
  Specialty leveraged mutual funds focus on specific investments that include sector funds, real estate, commodities, currencies, and other unique types like fund of funds.

The benefits to having leveraged exposure to the market through mutual funds is similar to the benefits of non-leveraged mutual funds, but they also allow an investor to build wealth using other people’s money, boost their returns, and allow for interest deductions come tax time. Furthermore, they also offer diversification benefits, and cost efficiency. Below, we looking at each benefit in more detail:

• Diversification
  One of the main advantages of investing in leveraged mutual funds is that it allows individual investors access to a managed and diversified portfolio of assets within the capital markets which would otherwise be difficult to do with a small investment. Using diversification is arguably one of the better ways to invest, in that it will yield higher returns and pose lower risk than any individual investment found within the portfolio. All investments involve some degree of risk, but the reward for taking that risk can be reduced by diversifying the investment. Keep in mind that with leveraged mutual funds, while diversification does help, there is the additional risks from borrowing on margin so take that into consideration as well.

• Cost Efficiency
  Having no per-trade costs means that investors do not have to worry about the costs incurred with buying and selling leveraged mutual funds, and with no performance fees allowed, mutual fund businesses are geared for scale. This allows them to invest smaller amounts over time instead of waiting to save up a chunk of funds to buy. This is called “dollar cost averaging” and is a recommended method of investing. Essentially, a young investor placing $5,000 in a leveraged mutual fund gets the same benefit as the high net worth individual who places $25,000,000.

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• Tax Considerations
  The government generally allows individuals to deduct interest paid on money borrowed to invest in stocks, bonds and/or mutual funds holding the same. The test for deductibility requires that borrowed funds be used for income-producing purposes. Be sure though to keep a proper paper trail for the IRS; failing to deduct the proper interest expense and/or failing to keep proper records could be asking for a tax headache later down the line.

See the 7 Essential Tax Tips for Mutual Fund Investors

Below we feature some of the best rated and best performing leveraged mutual funds based on Morningstar with at least $100 million assets under management are as follows:

• Biotechnology: Profunds Biotechnology UltraSector Fund (BIPIX)
• S&P 500: Rydex S&P 500 2X Strategy Fund (RYTTX)
• NASDAQ-100: Direxion Monthly NASDAQ-100 Bull 2X Fund Investor Class (DXQLX)
• Emerging Markets: Rydex|SGI Series Fund Trust Emerging Markets 2X Strategy Fund (RYWTX)

It is important to note that previous performance is not a guarantee of future performance, but these give investors idea of what leveraged mutual funds are available and what to look for.

Investors should only purchase a leveraged mutual fund if they understand all of the risks associated with them. As part of an active management style, they are typically held for a few days, since the rebalancing process can affect returns. For example, an investor that invests in a 2X leveraged fund should not expect returns of 30% if the S&P 500 increases 15% over that span of time. As always, be sure to conduct careful research and make prudent decisions. This approach will most likely result in a positive return than blindly investing in the hottest leveraged mutual fund trend.