Originally published in The Papyrus, Fall 2001. A Publication of Hermes Econometrics

Index funds & risk management
a winning combination

Managed mutual funds compare their returns to a benchmark index. Many actively managed U.S. stock mutual funds compare their returns to the S&P 500 index. Surprisingly, the S&P is difficult for most funds to beat. Over the last 10 years, actively managed funds are ahead of the underlying index just 23% of the time (source: Rydex & Morningstar).

Traditional index mutual funds mirror the indices; buying and selling derivatives and options to
replicate 100% of the underlying index. Leveraged index mutual funds mirror a multiplier of the
index.

When the underlying index is increasing, as in the late 1990’s, a leveraged fund will increase by the amount of the leverage. But when the underlying index is decreasing, the fund will decrease by the amount of the leverage.

For example Rydex’s Nova fund is leveraged at 150% of the S&P 500 index. The goal of the fund is to change by 1.5 times the underlying index. When the index increases by 10%, the Nova fund will increase by 15%.

When the index decreases by 10%, the Nova fund will decrease by 15%. In other words, the pleasure on the way up is equal to the pain on the way down. We recommend using risk management, which is demonstrated in the table below.