Traditionally, mutual funds have not been considered leveraged financial products. However, a number of new products have emerged that seek to reap the benefits of leveraged hedge funds in mutual fund packages. Because of the liquidity requirements governing all mutual funds, there are still strict rules regarding the degree of leverage a mutual fund may use. Nevertheless, the promise of accelerated earnings made possible by the use of debt to increase a fund's position has drawn many investors to leveraged mutual funds.

What Is Leverage?

In its simplest form, leverage is debt. To use leverage means to use borrowed funds to reap a greater gain than is otherwise possible. When a company or an investment uses leverage, it means it takes on debt to achieve a goal faster than it is able to with equity capital alone.

Leveraged investments use debt to increase their gains in a short period. By increasing the amount of money invested, they increase their potential profits. Conversely, they are liable to creditors if investments fail. For this reason leverage is inherently very risky; however, risk and volatility provide the opportunity for huge gains or crushing losses.

How Do Leveraged Mutual Funds Work?

Mutual funds are strictly limited with regard to the amounts of their portfolios that can be funded by borrowed money. This is because mutual funds are by definition highly liquid and the greater the proportion of debt to equity used in a fund's portfolio, the less liquid the fund becomes.

Hedge funds are well known for using huge amounts of leverage to take advantage of highly illiquid investment opportunities that require large amounts of capital and patience. Mutual funds are meant to be bought and sold easily and remain affordable for a wide range of investors. Leveraged mutual funds, therefore, seek to split the difference between these two asset classes by using a smaller amount of leverage while employing less traditional tactics, such as shorting and arbitrage strategies.

By law, the maximum amount of leverage a mutual fund can use is 33.33% of its portfolio value. If the portfolio is valued at $1 million, it may borrow up to $333,333 to increase its buying capacity. However, if assets in its portfolio fair poorly and the fund loses value, then it must reduce its leverage to remain within the required limits.

What Kinds of Mutual Funds Use Leverage?

Most leveraged mutual funds fall into the leveraged index fund category, which simply means they attempt to return a certain multiple of the returns generated by an index. For example, a 2X S&P 500 fund is specifically managed to return twice the returns generated by the S&P 500.

Conversely, some leveraged funds, called inverse funds, attempt to return an inverse multiple of an index's returns. If a fund manager believes the S&P 500 will lose value in the coming year, for example, her fund may be aimed at generating a profit that is twice the amount of the index's loss. A 10% drop for the S&P means a 20% profit for shareholders if everything goes to plan.

Other leveraged mutual funds employ a 130/30 strategy, where they borrow $30 for each $100 of portfolio value and use it to short some stocks while going long on others to beat a given benchmark. Other funds are less aggressive, employing a 120/20 strategy instead.