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Leveraged Mutual Funds Pose Greater Risks
n investor told me recently, "I don't buy stocks on margin. That's risky. Instead, I buy mutual funds."
That statement makes only partial sense. The accurate part is that buying stocks on margin can be risky. When investors employ margin, they are borrowing to buy more. That works well when the price of the stock bought actually rises (because leverage results in a greater gain). However, if the price of the stock bought falls, the investor suffers financially. The investor must deposit additional cash or securities to avoid having the stock liquidated (at an unattractive price) and possibly incurring a debt to the brokerage firm.
As a result, use of margin should be considered as a speculative tool for the aggressive investor. It is unsuitable for investors seeking safety of principal or modest growth.
The investor's comment to me is inaccurate in suggesting that mutual funds don't speculate by buying stocks on margin. Actually, most mutual funds allow their portfolio managers to borrow to invest. The concern is that this use of leverage is no less risky than the individual investor buying stocks on margin.
The good news is that most funds do not use leverage. As well, some funds using leverage do so only temporarily to satisfy customer redemptions. That is, rather than being forced to sell attractive stocks in the portfolio, portfolio managers hold those stocks and take out a loan to close a particular customer account. Overall, this is a wise course of action.
Nonetheless, there are some mutual funds that routinely speculate by borrowing money to invest in stocks. Investors need to know which funds do so, and must be comfortable with the speculation.
Our analytical database reveals that, as of 12/31/97, there are over 40 mutual funds that not only invest in stocks using leverage but also receive (out of 5 stars) just 2 stars or less (or no rating) for quality from Morningstar, an independent research firm.
Most speculative, from a leverage standpoint, is the Yorktown Classic Value mutual fund. Started in 1992, the fund is part of the American Pension Investors Trust family of funds. The fund has attracted only $13 million in assets to invest in large capitalization stocks that the portfolio managers believe to be undervalued. However, the fund utilizes 46.3% leverage. That means that while the fund has only $13 million in investors' money to invest, it speculates by borrowing an additional $6 million to hold stocks valued (today) at $19 million.
Other mutual funds using leverage to invest in stocks and receiving just 2 stars or less (or no rating) for quality from Morningstar are:
Landmark International Equity A; 8% leverage
Lord Abbot Balance A, C; 13% leverage
Oberweis Micro-Cap; 3% leverage
Pimco Stock Plus A, B, C; 2% leverage
Wachovia Quantitative Equity Y; 2.1% leverage
Investors in these mutual funds should read their prospectuses, contact the funds to determine why the funds utilize leverage, and determine whether the funds are appropriate for them given their investment objectives.
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Sponsored by James J. Eccleston, an attorney representing stockbrokers, financial planners and
investors nationwide in arbitration, litigation and regulatory matters, and a shareholder with the law firm
Shaheen, Novoselsky, Staat, Filipowski & Eccleston
P.C.(www.snsfe-law.com). This Web site contains material
of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
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