The Lost Decade

The Lost Decade: Why Most Retail Investment Portfolios Failed During the Subprime Meltdown—and What We Can Learn From It.

2

Table of Contents

Disclosures 3Executive Summary 5

What went wrong? 5The good news for today’s retail investors and financial advisors 5A note of caution 6The purpose of this paper 6

Introduction 7The Lost Decade: Ten years of Disillusion for Buy & Hold Asset Allocation 7Why It Was So Bad for Investors (and Not for Institutions) 9Why Modern Portfolio Theory Has Been So Widely Accepted 9Why Didn’t Asset Allocation Work? 9The Difference Change Has Made 10How Institutional Investors Have Performed Better 11

Alternative Strategies for Retail Advisors and Investors 12Options to consider 12Different Investor Types 14Retail Investors Are Embracing Sophisticated Alternative Strategies 14Why change is needed 14Alternative-Strategy Mutual Funds 15Portfolio Manager for an Accounting and Advisory Firm: Allen Gillespie, CFA 16Registered Investment Advisor: Gary Clemmons 16

Tactical Trading Tools 18Leveraged funds 18Leveraged mutual funds 18Leveraged mutual fund advisor: Daniel Wiggins 19Leveraged ETFs 19Leveraged ETFs in action: Todd Bessey 20Leveraged ETFs in action: Paul Ingersoll 21A Self-Directed Investor 21High-Frequency Traders 22High-frequency trader profile 22Suitability 23

The Effects of Daily Rebalancing: The Key to Using Leveraged ETFs Effectively 24The Bottom Line: Monitor and Act When Necessary 24Leveraged ETF Myths 24Myth #1 24Myth #2 27Myth #3 27Myth #4 28Myth #5 28

Conclusion 29 A new perspective on investing 29Glossary of Terms 30

3


Disclosures:

An investor should consider the investment objectives, risks, charges, and expenses of Direxion Shares carefully

before investing. The prospectus and summary prospectus contain this and other information about Direxion

Shares. To obtain a prospectus please visit www.direxionshares.com. The prospectus and summary prospectus

should be read carefully before investing.

Investing in the Funds may be more volatile than investing in broadly diversified funds. The use of leverage by a fund means

the Funds are riskier than alternatives which do not use leverage. These Funds are not designed to track the underlying index

for a longer period of time.

There is no guarantee that the funds will achieve their objectives. The ETFs are not suitable for all investors and should be

utilized only by sophisticated investors who understand leverage risk, consequences of seeking daily leveraged investment

results and intend to actively monitor and manage their investments. Due to the daily nature of the leverage employed, there

is no guarantee of amplified long-term returns.

Risks:

An investment in the Funds involve risk, including the possible loss of principal. The Funds are non-diversified and include risks

associated with concentration risk that results from the Funds’ investments in a particular industry or sector which can increase

volatility. The use of derivatives such as futures contracts, forward contracts, options and swaps are subject to market risks that

may cause their price to fluctuate over time. The Fund does not attempt to, and should not be expected to, provide returns

which are a multiple of the return of the Index for periods other than a single day. For other risks including correlation, leverage,

compounding, market volatility and specific risks regarding each sector, please read the prospectus.

Distributor: Foreside Fund Services, LLC.

The Use of Testimonials in this White Paper

The testimonials used in this paper may not be representative of the experience of other customers, the testimonial may not

be indicative of future performance or success, and the testimonials were voluntary and unpaid.

Although information and analysis contained herein has been obtained from sources Direxionshares believes to be reliable, its

accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made

in this report may not be suitable for all investors. This should not be considered an offer to sell or a solicitation of an offer to

buy any securities.

4


Disclosures:

An investor should consider the investment objectives, risks, charges and expenses of the funds carefully before

investing. The prospectus contains this and other information about the funds. To obtain a prospectus, please call

the Direxionfunds at 1-800-851-0511. The prospectus should be read carefully before investing.

Wilshire Funds Management is a business unit of Wilshire Associates Incorporated (“Wilshire®”). Wilshire® is a registered

service mark of Wilshire Associates Incorporated, Santa Monica, California. All other trade names, trademarks, and/or service

marks are the property of their respective holders. Wilshire is not affiliated with Direxion or any of its affiliates.

Risks:

The risks associated with the funds are detailed in the prospectuses which include Adverse Market Conditions Risk, Adviser’s

Investment Strategy Risk, Aggressive Investment Techniques Risk, Commodities Risk, Concentration Risk, Counterparty Risk,

Credit Risk, Currency Exchange Rate Risk, Debt Instrument Risk, Depositary Receipt Risk, Early Close/Trading Halt Risk, Emerg-

ing Markets Risk, Equity Securities Risk, Foreign Securities Risk, Gain Limitation Risk, Geographic Concentration Risk, Interest

Rate Risk, Intra-Calendar Month Investment Risk, Inverse Correlation Risk, Leverage Risk, Lower-Quality Debt Securities, Mar-

ket Risk, Market Timing Activity and High Portfolio Turnover, Monthly Correlation Risk, and Negative Implications of Monthly

Goals in Volatile Market.

Date of first use: October 3, 2011

Distributor: Rafferty Capital Markets, LLC.

The Use of Testimonials in this White Paper

The testimonials used in this paper may not be representative of the experience of other customers, the testimonial may not

be indicative of future performance or success, and the testimonials were voluntary and unpaid.

Although information and analysis contained herein has been obtained from sources Direxionshares believes to be reliable, its

accuracy and completeness cannot be guaranteed. This report is for informational purposes only. Any recommendation made

in this report may not be suitable for all investors. This should not be considered an offer to sell or a solicitation of an offer to

buy any securities.

5


Executive Summary

The so-called Lost Decade and its final blow—the

Market Meltdown of 2008—have been a wake-up call

for retail investors and retail financial advisors. Their

steadfast adherence to the buy-and-hold asset allocation

advocated by Modern Portfolio Theory resulted in

portfolio losses of 50% or more in the 18 months from

November 2007 through April 2009, during which

most types of securities—with the exception of Treasury

bonds and gold—fell in lock step. Perhaps even more

devastating for long-term investors who were advised

that large-cap equities should comprise the majority of

their portfolios, for the decade ending December 31,

2009, the S&P 500® Index (S&P 500) posted a total

return of -9.1%.

What went wrong?

While market analysts and economists will debate the

causes for years to come, one thing seems certain:

The markets themselves have changed. Markowitz’s

Modern Portfolio Theory (MPT) is based on the notion

that traditional asset classes—made up of stocks and

bonds—are not correlated: Their values do not rise

and fall at the same time. Yet, today’s global network

of trading exchanges, computer-driven investment

algorithms, and “flash” trades of millions of shares

in seconds have combined to radically change the

investment environment. In short, it has increased

market volatility to levels unimagined by Harry

Markowitz, transforming the static correlations that

formed the core of MPT into fluctuating correlations,

which change under different market conditions. These

new markets have created the need for new investment

theories, ones that include new non-correlating asset

classes and strategies for managing the risk/reward

equation.

Of course, not all investors were devastated by the

events of the last decade. Many institutional investors,

who long ago recognized the shortcomings of traditional

portfolio theory, used so-called alternative investment

vehicles to avoid—and even profit from—the recent

turbulent markets. Hedge funds, for instance, managed

a 6.3% annualized return for the same 10 years (as of

December 31, 2009) when the S&P 500 took such a

beating, according to Hedge Fund Research’s Weighted

Composite Index. Furthermore, the Harvard Endowment

Fund returned 8.9% per year for the decade ending

December 31, 2009, with significantly less risk than even

a traditional 60/40 stock and bond portfolio.

To accomplish these returns even during challenging

markets, institutions and other sophisticated investors

use asset classes and strategies outside of traditional

models to manage high-risk situations and to take

advantage of low-risk opportunities. These include:

• Additional asset classes, including real estate,

commodities, and currencies;

• Short positions, to take advantage of overvalued

market segments;

• Hedging, in order to reduce a position’s risk,

without losing its upside potential, or to avoid an

inconvenient selling situation; and

• Leverage, to amplify exposure with an efficient use

of capital.

The good news for today’s retail investors and financial advisors

Today, there are a growing number of investment

vehicles that offer access to the aforementioned

strategies that have formerly been available only to the

largest of investors. For Do-it-Yourself investors and

financial advisors, there are now more than passive

index Exchange-Traded Funds (ETFs) and index-based

leveraged ETFs. These provide exposure to worldwide

markets, commodities, currencies, and various classes

6


of equities and debt securities. For those investors who

prefer to defer tactical investment decisions to others,

there are alternative-strategy mutual funds, managed

by institutional managers, which offer exposure to long/

short equities, market-neutral strategies, commodities,

and global currencies.

A note of caution

Of course, it’s essential for retail investors and financial

advisors to fully understand these investment vehicles.

The very differences that make alternative investments

beneficial to many portfolios also put them outside

the experience of most typical investors and advisors.

Risk parameters can differ, time horizons can vary, and

some investment objectives—such as the concept of

daily objectives for most leveraged ETFs —can seem

unnatural to investors who have a traditional long-term

mindset. In addition, many of these types of alternative

investment vehicles can require more active monitoring

and management than those typically used by buy-and-

hold investors.

The purpose of this paper

In this paper, we take a close look at some of the

various types of alternative-strategy investment vehicles

that exist today—and which types are appropriate for

which types of investors or traders, as the case may be.

Investment professional user profiles have also been

included to provide context for some of the strategies in

action.

We also take a specific look at the common

misconceptions that exist regarding leveraged ETFs, and

seek to set the record straight. Consider the following:

• Leveraged ETFs are designed to meet daily

investment objectives, not to provide compounding

of returns beyond one day (as is commonly

expected in buy-and-hold investing);

• Leveraged ETFs serve as an effective way to gain

short exposure without the need to be subjected

to margin rules and limit investors’ losses to the

amount of their initial investments; and

• There is no quantifiable evidence that leveraged

ETFs can generate downward pressure on their

respective asset class or sector or introduce any

measurable volatility or systematic risk to the

markets.

The truth is that more investors and financial advisors

than ever before are questioning the wisdom of the old

long-only buy-and-hold investment approach, and are

looking for ways to profit from the new highly volatile

markets, whether they are going up or down. In fact,

advisors who are not offering risk management through

un-correlated investment strategies may be in danger

of losing new assets to the competition. The growing

number of alternative investment products is providing

retail investors and advisors with the tools they need to

create and manage far more sophisticated portfolios—

like the ones with which institutional managers have

succeeded for years. These tools are designed to enable

sophisticated investors to generate higher returns with

less risk in today’s highly volatile markets—and attempt

to help them avoid future Lost Decades and Market

Meltdowns.

7


Introduction

The Lost Decade: Ten years of Disillusion for Buy & Hold Asset Allocation

In the 18 months from November 2007 through April

2009, the Dow Jones Industrial AverageSM (DJIA) lost

more than half its value (53%), the second-worst

18-month drop in U.S. history (from September 1, 1929,

to April 1, 1930, the DJIA fell 55%), and the third-worst

bear market on record.

Chart

10 Worst Major U.S. Bear Markets

DateDuration

(mos.)Loss

1929 34 -90%

2000 32 -78%

2008 18 -53%

1937 56 -51.8%

1973 24 -47%

1919 21 -46.6%

1907 10 -45%

1917 13 -40.1%

1903 10 -37.3%

1968 18 -37%

Source: Bloomberg

For retail investors in particular, the 2008 losses

were devastating: Every asset class sustained losses

except two—Treasury bonds and gold—and even

“conservative” investments like municipal bonds fell

roughly 15%. Many seemingly “diversified” portfolios

lost from 20% to 50% of their value during the year.

People who depended on their retirement portfolios, as

well as advisors whose livelihoods were based on assets

under management, were financially devastated.

Unfortunately, the financial damage wasn’t limited to

the aftermath of the Sub-Prime Meltdown. Due in large

part to the meltdown, December 31, 2009, ended what

was, by all measures, the worst decade for stocks since

The Great Depression: Over the preceding 10 years, the

nominal S&P 500 Index lost 20% from its high at the

end of 1999, with a total return of -9.1%.

For retail investors, the new millennium started almost as

badly. According to Morningstar, the average annualized

return for U.S. equity mutual funds was 1.7% during

the first decade—culminating with only one fund out

of the total 3,833 mutual fund universe posting a gain

for calendar-year 2008: Forester Value Fund rose a mere

0.4%.

Source: Bloomberg

With virtually all asset classes used by retail investors

down during the past two years, those “diversified”

portfolios, which appeared so conservative, offered little

protection from the market maelstrom. For the majority

0

200

400

600

800

1000

1200

1400

S&P 500®

NASDAQ®

Major US Stock Indices Total Returns 12/31/99 - 12/31/2009

Co

rrel

atio

n

IndexAverage Annualized Returns 12/31/00-12/31/10

Total Return 12/31/00-12/31/10

S&P 500® Index 1.41% 15.07%

NASDAQ Composite Index -0.14% -1.41%

Past performance is not an indicator of future results. Index performance is not representative of a specific fund or products. One cannot invest directly in an index.

8


of retail investors, especially those Baby Boomers who

are in their peak earning years leading up to retirement,

those 10 years with little or no portfolio growth marked

disaster for their retirement plan strategies.

Exceptions to “the rule”

Yet, all investors didn’t suffer equally during the past

two tough years or even in the past flat decade. That’s

because while most popular asset classes were taken

down with the markets, ALL asset classes weren’t.

Consider that:

• Investors who put $10,000 into S&P 500 stocks on

Dec. 31, 1999, had $9,090 10 years later, at the

end of 2009. The same amount invested in 10-

year Treasury notes would have grown to about

$18,000 (a 6.1% annualized return);

• The Reuters/Jefferies CRB Index of 19 raw materials

increased 3.3% per year, to $13,803;

• Gold futures, which rose 14% per year, would have

yielded $37,852.

Those who benefited during the decade were short-

term, tactical investors who were able to take advantage

of the volatility in the stock market. Who were the

investors using these classes for portfolio protection

and profit? One group was hedge fund investors:

Their average annualized return was about 6.3% over

the same 10-year period, according to Hedge Fund

Research’s HFRI Fund Weighted Composite Index.

Another group managed to beat the Lost Decade—

the large Institutional Investors. For example, the

endowment funds for Harvard and Yale Universities

have been using alternative asset classes and strategies

to produce higher, more consistent returns with less

volatility for decades. The two multi-billion-dollar funds

have consistently produced a track record of high

risk-adjusted returns. Over the long haul, including the

most tumultuous market since the Great Depression—

from July 2008 through June 2009—these institutions

have carved out very strong, long-term performance.

Consider that from 1985 to 2008, the combined

Harvard and Yale Endowments posted a 15.95% annual

compound rate of return versus the S&P’ 500’s 11.98%,

with far lower risk: a standard deviation of 9.75 versus

15.6 for the S&P 500.

Source: The Ivy Portfolio by Mebane T. Faber & Eric W.

Richardson © 2009 John Wiley & Sons Inc.

Specifically, the Harvard Endowment Fund has delivered

annualized returns that have consistently outperformed

a typical 60% stock-/40% bond-allocated portfolio

over time. During the past 10 years, the Harvard

Management Company (HMC) managed an average

annual return of 8.9%, while the S&P 500 Index was

losing 0.99% a year and a 60/40 portfolio was returning

1.4% annually. HMC has generated significant alpha, in

great part through the use of alternative strategies and

asset classes. Financial advisors have been preaching the

commandments of diversification and asset allocation to

their clients for decades. Today, in hindsight, reality may

cause many to consider a more active solution.

Sources: Harvard Gazette, January 2010, Bloomberg

Results of the Endowment Approach to Investing

1985-2008 Annual Compound Rate of Return

Volatility (measured by Standard Deviation)

Yale and Harvard Endowments Combined

15.95% 9.75σ

S&P 500® Index 11.98% 15.6σ

Results of the Endowment Approach to Investing

10 Year Annual Returns

20 Year Annual Returns

Harvard Endowment Fund 8.9% 11.7%

S&P 500® Index -0.99% 8.23%

Typical 60%stock/40% bond portfolio

1.4% 7.8%


9


Why It Was So Bad for Investors (and Not for Institutions)

In 1952, a 25-year-old, future Economics professor

named Harry Markowitz first published his Modern

Portfolio Theory under the title “Portfolio Selection”

in The Journal of FINANCE. Markowitz considered

the effects of asset risk (as measured by the historic

range of returns or “volatility” of a specific stock) on

probable investment portfolio returns. He was the first

to postulate the now widely held view that a well-

diversified portfolio of individual stocks will be less

risky than holding any individual stock. The risk in such

a diversified portfolio, he said, comes not from the

volatility of each stock, but from the covariance—the

difference or similarity—between the stocks’ returns. He

concluded that portfolios get the highest returns with

the least amount of risk if they combine stocks with

historically “low-correlated” returns: that is, if the stocks

have a history of going up and down at different times.

Markowitz’s now 60-year-old theory was further

advanced in 1986 by the Brinson Hood Beebower study,

which concluded that only 10% of a portfolio’s risk and

returns comes from the individual stocks in it, while the

remaining 90% results from the asset classes that the

portfolio’s stocks fall into. Put another way, Brinson et al

found that the gains or losses of each stock matter very

little to the overall performance of a portfolio, while the

relative weightings of classes into which the stocks fall

(small-cap value, large-cap growth, corporate bonds,

etc.) matter a great deal. Brinson’s findings redefined

Modern Portfolio Theory to mean that the allocation of

assets among different types of investments with unique

characteristics reduces the probability of sustaining a

large loss. This change launched an entire generation

of financial advisors who eschew picking individual

stocks in favor of constructing portfolios out of diverse

allocations of mutual funds.

Why Modern Portfolio Theory Has Been So Widely Accepted

MPT’s orderliness and simplicity make it easy to

understand: A portfolio constructed of a well-diversified

basket of stocks (mutual funds) allocated between

various non-correlating asset classes will offer investors

the highest possible returns for the lowest possible risk.

Ideas like this that are easy to understand are easily

sold—and bought. Its conclusion leads to an elementary

methodology of investment management: “Set it.

Rebalance every quarter. Repeat.”

Financial advisors have been preaching the

“commandments” of diversification and asset

allocation to their clients for decades. Real

market performance over the last few years,

however, forces investors to challenge this

theory. Disparate asset classes, with distinct

risk profiles, all went down together in 2008

and early 2009, taking trillions of dollars of

investors’ assets with them.

Why Didn’t Asset Allocation Work?

It all makes sense in theory. But theories, by definition,

must rely on assumptions. MPT and Asset Allocation

were born and bred in academia, an environment

where assumptions can be made, controlled, isolated,

and plotted on graphs. It’s simple and elegant, and can

lead into various mathematical proofs and equations,

which may help to explain why it has become so widely

accepted. Books will be written on why buy-and-hold

strategic asset allocation has failed for more than a

decade. But some causes seem obvious if we look at the

realities of today’s financial markets.

10


Traditional asset allocation relies on diversification

into asset classes that are not correlated; that is, their

returns rise and fall at different times. Many financial

advisors and retail investors have assumed diversification

from holding say, International Large Cap Blend stocks

and U.S. Large Cap Blend stocks. Are they really that

different in terms of risk and correlation? The answer

is that correlations between asset classes in today’s

markets aren’t static—they’re fluid: Assets that once

were correlating can become non-correlating under

certain market conditions, and vice versa. Most notably,

from July 2008 through June 2009—a period in the

decade when true diversification would have been most

valuable—the traditional eight asset classes fell in lock

step (except for Treasuries, as noted earlier). When

non-correlating assets become correlating, portfolio

diversification disappears, and risk goes up—sometimes,

way up.

The Difference Change Has Made

10-Years of Market Volatility

S&P 500® Index Barclays Capital US Bond Index Volatility Index (VIX) 10 Year VIX Average

0

10

20

30

40

50

60

70

80

90

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

$16,000

$18,000

$20,000

12/31/99 12/31/00 12/31/01 12/31/02 12/31/03 12/31/04 12/31/05 12/31/06 12/31/07 12/31/08 12/31/09

$18,475

$9,090

Gro

wth

of

$10,

000

VIX

Source: Bloomberg

1.00 0.990.93 0.92 0.90 0.90

-0.24-0.27

1.00 0.990.94 0.95

0.85

0.94

0.05

-0.25

-0.40

-0.20

0.00

0.20

0.40

0.60

0.80

1.00

1.20

S&P 500 Index

DOW JONES INDUS. AVG

RUSSELL 2000

GROWTH IDX

RUSSELL 2000 VALUE

IDX

FTSE 100 MSCI EAFE Citigroup Non USD WGBI All

Mat

BarCap US Agg Total

Return Val

Correlation of Indices to the S&P 500 Index

2008 2009

These fluctuations in correlation

are at least in part due to dramatic

changes in the way markets work.

Gone are the 1950s style “open

outcry” trading pits filled with

face-to-face buyers and sellers,

replaced by a complex web of

electronic exchanges driven by

computer-trading algorithms.

Proprietary traders use high-speed

computers to execute “flash”

trades of millions of shares in a

hundredth of a second, thousands

of times a day, on exchanges all over the world. All this speed means a great deal more volatility in the markets. One of

the reasons for the market’s 10 years of negative returns was this new level of volatility. As measured by the S&P 500

Index, U.S. equities from 1999 through 2009 experienced two major volatility shifts: First, the 2000 to 2002 technology

bubble, when the index lost 37.5%, and volatility climbed to 46% in August of 2002. Second, in 2008 and 2009, the

market experienced the highest-level volatility ever recorded.

Source Bloomberg. Diversification does not protect against a

loss or ensure a gain.


11


Unfortunately, Asset Allocation worked better in

the old, less volatile, predictably correlating markets

for which it was designed. In today’s more volatile

markets, asset allocators actually “steer” into down

trends and away from up trends in order to maintain

their allocations. By selling the “winners” and buying

the “losers” at arbitrarily predetermined times (e.g.,

quarterly), advisors and investors often lose a portion

of the ride up, and then gain an extra portion of the

ride down. For example, an investor may have good

reason to believe that International Large Cap stocks will

under-perform for a period of time, but would continue

to hold them, and in fact, may buy more if negative

returns in that class (or positive returns in another asset

class) shift the allocation of the portfolio. Conversely,

if the fundamentals of small caps still look great after

a quarter of stellar returns, strict MPT followers will still

sell the winners even if all signs point to more gains for

the next quarter, and beyond.

How Institutional Investors Have Performed Better

One of the reasons that institutional investors such

as Harvard Management Corporation fared better in

recent years than retail portfolios is that they understand

that risk management—protecting the assets that they

manage—is a critical component of their investment

strategy. Risk management, as these institutional

investors see it, involves two components: minimizing

exposure to high-risk situations, and increasing their

participation when the risk is low. To accomplish this

within their portfolios, savvy institutions use alternative

investment products and strategies that fall outside of

a traditional asset allocator’s menu of mutual funds. In

light of their investment experience during the past 10

years and more, it seems reasonable to ask: If some of

the most successful long-term investors have been using

alternative strategies and asset classes to manage risk

for decades, why isn’t everyone following their lead?

First, there is the perception of higher risk associated

with alternative asset classes and strategies. These

institutional fund managers use leveraging and other

speculative investment practices that average investors

typically associate with higher risk. Some classes of

alternatives can also be highly illiquid, and, often,

alternative investment funds are not subject to the same

regulatory requirements as, say, mutual funds. While

there are additional risks associated with alternative

strategies, sophisticated financial professionals

implement programs to offset, manage, and monitor

these risks. In fact, most institutional managers would

say that they use alternatives to lower standard deviation

and offset the risks associated with other holdings.

Not everyone has access to the resources that the

managers of a $30 billion endowment or hedge fund

have at their disposal. At that asset level, resources,

staff, technology, and infrastructure abound. Institutions

may even designate a Chief Risk Manager, overseeing a

department dedicated to examining the best ways to use

alternative strategies and asset classes to hedge portfolio

risk. Implementing those strategies and managing them

day in and day out, requires 100% hands-on attention

by experts. Fundamental and technical analysis, short

strategies, leverage, counterparty risk and illiquidity

require very sophisticated management expertise. These

realities have all tilted the playing field in favor of the

largest players—until now.

12


Alternative Strategies for Retail Advisors and Investors

As we’ve seen, during the recent financial crisis, almost

anywhere you were invested would have been highly

correlated, leading to disastrous investment results,

which is why many people today have largely retreated

away from the equity markets and are looking for a new

approach. Investment advisors and retail investors who

believe in managing risk by diversifying portfolios but

aren’t satisfied with how it’s been working for the last

decade or more may want to consider adding alternative

asset allocation strategies like the ones detailed below,

to their overall portfolio management toolkit. As you’re

probably aware, these asset allocation strategies aren’t

“new,” but they are more sophisticated versions of the

strategies with which you’re probably familiar, bringing

them closer to the strategies that institutional investors

have been using successfully for many years.

Options to consider

By either applying active management or using

alternative-class or alternative-strategy mutual funds,

here are a few possible ways that well-allocated MPT

portfolios can be updated to mitigate—and indeed,

profit from—today’s increased market volatility and

inefficiencies:

1. Incorporate additional asset classes, including real

estate and commodities. These alternative asset classes

may have the potential to:

• provide greater diversification and enhance all asset

allocation models;

• offer low correlation to stocks and bonds;

• serve as an effective hedge against inflation; and

• provide additional risk-adjusted returns over time to

a diversified portfolio.

2. Consider short positions (in addition to long

positions) in order to take advantage of trends or to

hedge risk. Traditional asset allocation only allows for

long positions, which provide returns when stocks

appreciate. If investors have learned anything over the

past 10 years, it’s that markets move in both directions.

Whether using margin, or securities with built-in short

exposure, the ability to profit—or to hedge against

losses—in down markets is what separates the most

successful institutional and retail investors from the rest

of the pack.

3. Incorporate hedging techniques. Suppose an investor

is happy with the recent performance of her portfolio;

however, she is now anticipating a market correction

and is concerned about losing recent gains. She may

initially be inclined to sell portfolio holdings and move to

a cash position, but is well aware of the disadvantages

of this market-timing approach—including the possibility

of incurring capital gains taxes and the prospect of

missing out on future rallies. One solution? Apply

a hedge. Hedging is the strategy of purchasing an

inversely correlated investment to reduce the risk of

adverse price movements. A hedge can help to protect

your gains and reduce volatility in a declining or volatile

market. In the above instance, it can provide an investor

with the ability to stay long and still profit if the market

continues to rally without having to incur taxable gains.

In the illustration on the next page, the short position

is acquired using a leveraged monthly bear 2x (inverse)

mutual fund.

13


4. Apply leverage to make tactical shifts between asset

classes to seek better returns, reduce risk or both—without

applying more capital. Here’s an example: Suppose an

investor has a bullish one-year outlook on stocks in the S&P

500. He currently has a diversified portfolio containing a

modest allocation to a popular S&P 500 mutual fund. He

would like to increase his exposure to the index, but does

not want to commit additional capital to invest. How may

he accomplish this? By repositioning $20,000 of $100,000

in the S&P 500 fund into a Leveraged S&P 500 Bull 2x Fund,

$40,000 of additional exposure is created, increasing his

total exposure to the S&P 500 from $100,000 to $120,000,

without adding more capital.

The use of leveraged funds provides the opportunity to

improve portfolio diversification because it generates beta in

excess of allocated assets. Put another way: Leverage frees

capital that can be used to make higher allocations to asset

classes already in the portfolio which have low correlations

to equities and fixed income securities; and/or to allocate

capital to asset classes that were not previously represented.

This use of leverage is one that has increasingly found favor

with institutional investors. The additional diversification

is used to seek improvements in risk-adjusted returns—

extending, changing, and improving the expected returns of

the portfolio without a commensurate increase in risk.

Symbol Fund Name 1 Yr 5 Yr S/I Inception date

DXSSX Direxion Monthly S&P 2x Fund -41.05 - -21.65 5/1/2006

SPY SPDR S&P 500 14.89 2.25 8.03 1/29/1993

IWN I Shares Russell 2000 Value Index 24.30 3.42 9.14 7/24/2000

IWS I Shares Russell Mid Cap Index 24.44 3.95 8.06 7/17/2001

EFA iShares MSCI EAFE 7.53 2.35 5.61 8/14/2001

-16

-14

-12

-10

-8

-6

-4

-2

0

2

4

Portfolio A Portfolio BUlcer Beta Stdev Total Return

Portfolio A 10.01 1.18 34.67 -13.89

Portfolio B 4.56 0.49 14.68 -5.59

Strategy in Action

The chart to below illustrates performance of two

portfolios, one long only and one hedged during then

period of 4/30/10 - 6/30/10 - A particularly volatile period in

the equity markets.

Portfolio A Holdings: Long Only Portfolio

SPDR S&P 500 25%

iShares Russell 2000 Value Index Fund 25%

iShares Russell MidCap Index Fund 25%

iShares MSCI EAFE Index Fund 25%

Portfolio B Holdings: Hedged Portfolio

SPDR S&P 500 20%

iShares Russell 2000 Value Index Fund 20%

iShares Russell MidCap Index Fund 20%

iShares MSCI EAFE Index Fund 20%

Direxion S&P 500 Monthly Bear 2.0x* 20%

*As of 9/30/2009, the investment objective of Direxion S&P 500 Monthly Bear 2.0x has changed from seeking daily investment results, before fees and expenses, of -250% of the price performance of its benchmark to seeking monthly investment results, before fees and expenses, of -200% of the price performance of its benchmark. The fund’s gross/net expense ratio is 1.90%/1.90%.The performance data quoted represents past performance through 12/31/10; past performance does not guarantee future results; the investment return and principal value of an investment will fluctuate; an investor’s shares, when redeemed, may be worth more or less than their original cost; current performance may be lower or higher than the performance quoted. Please call 800-851-0511 to obtain current month-end performance information. For additional information, see the fund’s prospectus.

14


Different Investor Types

In the most basic sense, all investors can be divided into two

categories:

• Do-it-Yourselfers—Those who have a true passion

for the markets, have an interest in gaining a deep

understanding of the markets and the various

security types and why they behave the way they

do, and want to take the reins to make their own

investment decisions.

• Those Who Defer to Others—Those who put their

trust in an advisor, an asset management firm, a

prescribed portfolio model or investment strategy,

or perhaps some combination of all three.

The “Do-it-Yourselfers” have historically been much more

inclined to utilize tradable securities (ETFs, Leveraged ETFs,

options, futures, individual equities, etc.) to seek short-term

goals, and they have been much earlier adopters of alterna-

tive assets classes and strategies.

“Those Who Defer” have typically overwhelmingly favored

a “buy-and-hold,” long-only, traditional asset allocation ap-

proach with exposure to only stocks, bonds, and cash. How-

ever, recently that paradigm has begun to shift. More and

more, these investors, and the financial professionals who

advise them, have seen the need to incorporate alternatives

into their portfolios. Fortunately, this has become easier,

because, as mentioned above, many new alternative-strategy

mutual fund products have been introduced to the market

place, allowing these types of investors to maintain their buy-

and-hold approach while gaining exposure to the new funds

in which they are now interested.

Both types of investors should take good care to determine

if either strategy is suitable. Particularly, those who use

the tradable securities mentioned above must have a solid

understanding of the securities’ composition and expected

behavior and must plan to monitor them closely.

Retail Investors Are Embracing Sophisticated Alternative Strategies

Historically, alternative assets and strategies for risk

management were options for only those investors who

had access to the resources of the largest institutional

investment firms, such as Wilshire Associates, JPMorgan

Chase, or State Street Global Advisors. Recently,

however, access to these sophisticated—and highly

successful—strategies has expanded through a

convergence of traditional and alternative investment

products.

Why change is needed

If we’ve learned anything over the past decade, it’s this:

Investors face a new frontier in markets that are vastly

more sophisticated than could have been anticipated

by Markowitz in 1952. Today’s investors and financial

advisors need to make the most of every opportunity

in both “up” and “down” markets. Thankfully, today

there are more options than ever to amplify the benefits

of the (new) efficient frontier.

In fact, any advisor who is not offering solutions

for managing risk with un-correlated investment

strategies—ones that are transparent and liquid—may

be losing new assets to the competition. Within the past

few years, alternative asset classes and strategies gained

significant traction with Registered Investment Advisors

and high-net-worth investors through the introduction

of products that combine the use of sophisticated,

non-correlating strategies within buy and hold “40-Act”

(Investment Company Act of 1940) mutual funds offered

by institutional managers.

According to Strategic Insight, by the end of 2009,

investors held more than $110 billion in alternative

mutual funds in the U.S. and Europe, with the largest

flows going into long/short, market-neutral, commodity,

15


portfolios. The good news is that over the past several

years, many open-end mutual fund products have been

developed to help.

These so-called “Alternative Mutual Funds” have been

introduced into the marketplace to provide the broader

investing public with access to alternative asset classes

and institutional-style alternative strategies. These funds

are generally designed to accomplish three high-level

goals:

1. Provide diversification and additional sources of

returns with low correlation to traditional asset classes;

2. Offer access to short-term market opportunities; and

3. Provide tools to manage overall portfolio risk.

These funds come in many forms. Some are primarily

designed to simply provide access to alternative asset

classes, such as managed futures, real estate, or

currencies. Others are designed to implement alternative

strategies, while still others are design to do both—for

example, long/short management futures funds—such

as:

• Long/short or long/neutral strategies;

• Hedge fund replication;

• Absolute returns strategies; or

• Tactical asset allocation.

A growing number of investors have recently decided to

incorporate these funds into their portfolios in modest

proportions (perhaps 10% to 30%), because doing so

allows them a way to supplement their traditional asset

allocation strategies without having to change the way

they manage their portfolios from day to day, or month

to month. For this reason, alternative funds can be very

attractive to the group of investors described above as

“Those Who Defer to Others.” These investors prefer

to defer short-term investment decisions to a fund

manager or methodology of an alternative strategy fund,

and currency funds. These funds provide easy, cost-

effective access to sophisticated, institutional-style

investments, including trading expertise to help manage

risk and pursue growth.

Traditional institutional-only managers are applying their

expertise to these funds, providing the masses with

access to alternatives previously available only to the

largest and wealthiest investors. Whether investors and

advisors want to take an active “hands-on” approach,

trading futures, or leveraged tactical trading funds or

are interested in managed buy-and-hold funds that

offer exposure to alternative class assets and strategies,

they should at least consider the many new alternatives

for implementing the same strategies that today’s

institutions use to prosper in the new efficient frontier.

Alternative-Strategy Mutual Funds

At the end of 2009, many traditional buy-and-hold asset

allocation investors were very disappointed with their

portfolios’ returns over the decade. These investors

became frustrated with the markets, their portfolios,

and even their advisors—who had repeatedly told them

that buying and holding traditional asset classes in their

portfolios would, over the long run, eventually provide

their desired returns.

Now, with eyes wider open, many investors are looking

for other ways to build portfolios with which they can

feel more comfortable in various market conditions.

Many wise financial advisors are also looking for

additional options to both respond to their clients’

demands and to differentiate themselves from other

advisors who have not yet expanded beyond traditional

investment options. However, for both groups, old

habits die hard. These types of investors and advisors

have typically not been interested in drastically changing

their overall investment approach, nor the amount

of time and attention they devote to managing their

16


easier to adjust the portfolio for expected returns or

hedging risk. “In some of our asset classes, we have

a permanent long/short allocation,” he says. “We’re

looking for excess returns with the lowest risk possible.

We don’t usually exit our long or short positions, but we

do change our weightings, depending on the expected

returns. This provides more consistency.”

Gillespie reduces the risk in his portfolios by managing

for equity-like returns in low-correlating asset classes.

The result from more diversification: portfolios with

more efficient risk reward ratios. He uses a trend

following commodity mutual fund to make that

possible. “Capturing trends in commodities can double

the effect of the asset class,” he says, “making them

more like equities than bonds, without affecting the

correlation. It’s a huge breakthrough to have access to

these alternative strategy products that have formerly

only been available to institutions. We use these types of

funds to get exposure because they are transparent and

liquid. Most of our clients have private businesses; they

don’t need additional complications.”

Registered Investment Advisor

Gary Clemmons is a principal with Texas Capital

Management, a registered investment advisor in

Baytown, Texas. He’s been an independent advisor since

1986, and the majority of his clients are petrochemical

retirees. “My focus has always been to find clients and

to keep them,” he says. “So, I never bought into the

buy-and-hold philosophy. I figured my clients would

be happier if we avoided major market downturns, so

I became a tactical asset allocator, before I even knew

what it was called. The market charts used to come

in a big folder; we’d thumb through them looking for

patterns.”

Consequently, Texas Capital Management focuses

on creating client portfolios with non-traditional

instead of attempting to implement their own alternative

strategy using more hands-on, short-term trading

vehicles. Alternative funds are also typically designed

to provide more downside protection in volatile or

downward-trending markets, which is very attractive to

those who have struggled to deal with the recent hyper-

volatile environment.

Alternative-strategy mutual funds in action

The following testimonials provide examples of advisors

who have successfully incorporated alternative strategies

and funds into their clients’ portfolios.

Portfolio Manager for an Accounting and Advisory Firm

As Chief Investment Officer at Elliot Davis Investment

Advisors in Greenville, South Carolina, Allen Gillespie,

CFA, conducts research and chooses products for his

firm’s $800 million in client portfolios. Much of that

comes from high-net-worth accounting clients who

own their own businesses, and their associated 401(k)

s. Gillespie is quick to point out that he’s not trying to

predict the direction of the markets, but he is trying

to make the most out of what the markets offer.

“We’re an asset allocation practice looking for positive

expected returns in a broad range of asset classes, while

mitigating the risk,” he says. “But, we believe that a

long-only approach is doomed to under-perform. You

need to be on both sides of a trend to have the most

efficient portfolio possible.”

To get adequate diversification, he uses 25 or so asset

classes in his portfolios, including some alternative asset

classes such as commodities and merger/arbitrage.

With that many asset classes, he’s virtually assured of

low correlations that allow him to hedge any position

and reduce his risk exposure. He also uses long and

short mutual funds in many asset classes, making it

17


asset allocations, using actively managed funds and

ETFs. “The last thing you want to be is disruptive to

a portfolio manager, so we don’t move in and out of

managed funds very much,” he says. “But when you

have tradable index funds [ETFs], it gives you a greater

degree of freedom.” His portfolios include holdings in

the S&P 500, NASDAQ, and Wilshire indices, as well as

currencies, commodities, investment-grade-quality bonds

and even junk bonds (“I love ‘em,” he says).

As for investment strategy, “It’s important to go with

your gut feeling,” Gary says. “When you’ve been doing

something for a long time, you develop instincts. If you

listen to it, the market will tell you where it’s going. We

watch for trading patterns: When something’s different,

it puts you on guard. When corn prices start to rise, or

the federal budget goes out of control, or the dollar

continues to fall, these are all clues. How did I avoid the

dot.com crash? If you are willing to listen to the market

it will tell you a lot.” His typical position has about a

.4 beta (less than half the volatility of the S&P 500). “I

used to have a .11 beta, I found that clients are willing

to except a little more risk if you can deliver an above

average return,” he says.

He’d prefer to go to cash when a position looks poised

to go south, but not always. He also uses a tactical asset

allocation fund to take advantage of those opportunities.

For instance, he took a 25% short position in August

2008. As a result, his average portfolios were only down

about 5% while the S&P 500 was down 38%. Over the

past 10 years, his portfolios have an average annual net

return of 6.2%, while the S&P 500 has posted -3%. “I’m

not a gambler,” he says. “I have clients that go back to

the 1980s.”

18


Tactical Trading Tools

“Do-it-Yourselfers” seek the assistance of alternative

strategy tactical investments for similar reasons—that is,

to find short-term market opportunities, to diversify their

portfolios, and to reduce portfolio risk—but they tend to

take a very different approach. They prefer to do their

own research, build their own strategies, and find their

own investment vehicles that will provide liquid, instant,

and exacting exposure to the asset classes and sectors

that their strategies require.

These “Do-It-Yourself” investors come in many different

forms, from the most sophisticated and well-funded

institutional traders to educated, self-directed individual

investors, and various other investment professionals in

between. (See the investor profiles below.) The types of

tools that these investors are most attracted to include:

• Individual equities (traded actively);

• Passive index ETFs;

• Futures, options and other derivatives; and

• Index-based leveraged and inverse mutual funds

and ETFs.

These instruments tend to be easily accessible to

investors and are generally both liquid and nimble,

making them practical trading tools for the execution of

short-term trading strategies. However, these investment

vehicles are not actively managed by a Portfolio Manager

to seek an investment objective (beyond seeking to

track a benchmark in the case of the ETFs and leveraged

index-based mutual funds). So investors who are using

these tools carry their own convictions about the

markets (both short- and long-term) and have their own

directional perspective on the respective asset classes

and sectors in which they choose to invest. They build

their own overall portfolio strategies and make their own

decisions as to how these investments fit together to

help them reach their objectives.

Leveraged funds

For actively trading retail investors, the most potentially

attractive of these strategies tends to be leveraged

funds: as actively traded individual stocks offer little

diversification; passive ETFs require more capital to get

the same level of exposure; and futures and options

require a margin account and are considerably more

complicated.

There are two kinds of funds that offer leveraged

investments: leveraged mutual funds and ETFs. Both

provide magnified exposure to a specific index in either

a positive fashion in the case of a bull fund, or in an

inverse fashion, in the case of a bear fund. Each dollar

invested provides 200%, -200%, 300% or -300%

of exposure to the performance of the benchmark,

which means 2 or 3 times the risk and volatility. Most

leveraged funds offer this magnified exposure on a daily

basis, meaning the funds’ net assets to market exposure

ratio is reset every day. It also means that the fund only

seeks to track its benchmark index at its stated leverage

point (2x, -2x, 3x, -3x) for a single day. It should not

be expected to track the benchmark index’s cumulative

return for periods greater than a day.

Some other mutual funds and Exchange-Traded Notes

(ETNs) do seek a monthly goal: They are designed to

track the benchmark index at a stated magnified rate

for a period of one calendar month. The net assets to

market exposure ratios are reset typically on the last

business day of each month.

Leveraged mutual funds

Today, the leveraged mutual fund business is largely

made up of active investors whose trading doesn’t

require intra-day access—such as a practice that focuses

on managing multiple client accounts and is trying to

apply an exact asset allocation across all client accounts.

19


This is difficult to do using ETFs, because it is typically

not possible to trade partial shares. Also, some advisors

don’t want to expose their clients to the commission

costs of trading large volumes of ETFs. There’s also a

group that sees more value in a monthly fund rather

than one that resets daily.

Leveraged mutual fund advisor: Daniel Wiggins

Daniel Wiggins is a principal advisor with Black Label

Wealth Management in Durango, Colorado. He runs

depending on their goals and desire for taking risk:

• A conservative fixed income portfolio comprised of

85% long/cash High Yield and 15% long/short 10

Year U.S. Treasury funds;

• his Black Label Portfolio, made up of 20% long/

short S&P-500, 20% long/short Emerging Markets,

and 20% long/short 10 Year U.S. Treasury funds;

• Platinum Plus portfolio that invests in 100% long /

short Emerging Markets.

The holdings in all three funds are exclusively leveraged

mutual funds.

Wiggins uses what he calls a “multi-manager” system,

in which he purchases the signals (buy-sell-hold

recommendations) of 13 outside managers (some of

these “managers” are actually models, not real people)

who don’t know about the others. He then forms his

managers into two teams: the long-term team and

the short-term team, keeping some managers “on

the bench,” tracking them until their performance

demonstrates they should replace one of the first-team

managers. The consensus of the long-term sets his

predominant position every four to six weeks, while the

short-term team signals which of his long-term positions

to hedge temporarily.

“It’s not always good to be in the market,” he says.

“Leveraged index-based funds enable me to be nimble.”

Wiggins is only in the market about 65% of the time

and is “all in” only about 10% of the time. His goal:

portfolios that never give back more than 10% before

they recover. “Clients leave when you have a big draw-

down,” he says. “I only lost two clients in ’08.

“With leveraged funds, I can manage everybody’s

portfolio identically, commission free. And with no

redemption fees, I can be nimble to reduce or eliminate

losses,” he says. “I can also use 50% of my portfolio

to be 100% long. So the money I make on the money

market is automatic alpha.”

Leveraged ETFs

Institutional investors use many complex, sophisticated

tactics and investment products to implement the four

previously mentioned strategies: expanding to additional

asset classes, going short, hedging, and using leverage.

Many of those tactics are beyond the expertise and

resources of traditionally oriented retail advisors and

investors. To make these strategies available to the retail

and advisory markets in a manageable form and at a

reasonable cost, some companies have combined the

growing popularity of ETFs with a leverage component,

creating a new investment vehicle commonly known as

leveraged ETFs.

Historically, most of the investors who traded leveraged

mutual funds (before leveraged ETFs existed) were

active traders. Many of them flocked to leveraged ETFs

when they first launched, because they liked the added

flexibility of intra-day trading. ETFs are thought of more

as equities than they are funds, and their initial growth

really came from equity (and derivative) traders, not from

mutual fund users deciding they would rather use an

ETF. Many equity traders jumped on board soon after

the leveraged ETF came out, because they like the more

3 model portfolios for his retail and sub-advising clients,

http://www.blacklabelwealth.com

20


broadly diversified equity that had built-in extra leverage,

with no need for a margin account. Today, the leveraged

ETF industry has grown dramatically, primarily within the

active trading world (and mainly with those who have

historically been equity trader types), while the leveraged

mutual fund world is much smaller—mostly for those

looking for exacting allocation percentages without

commissions.

Like traditional ETFs, leveraged ETFs use a currently

available index to provide asset class exposure (e.g., the

Russell Midcap® Index or the MSCI Emerging Markets

Index). Then, the leveraged ETF managers use futures,

swaps, options, or other derivative contracts to either

increase the exposure to that index (in the case of a bull

leveraged ETF) or increase inverse exposure to the index

(in the case of a bear leveraged ETF), by a factor of 2x or

3x the index. That’s the key to leveraged ETFs: because

investors are buying a fund (as opposed to individual

securities on margin) that uses derivatives to magnify its

exposure to an index’s gains or losses (by 2x or 3x), the

investor’s potential loss is never more than the amount

of their initial investment. In this way, investors get 2x

or 3x the investment exposure without putting up 2 or

3 times the investment capital, or borrowing funds that

would ultimately have to be paid back.

Although leveraged ETFs share some similarities with

non-leveraged ETFs, there are two key concepts that

impact the way they are managed and the way they

perform:

• Leverage: In the case of a 3x fund, each

dollar invested provides $3 of exposure to the

performance of the benchmark, which means

300% of the risk and volatility.

• Daily investment objectives: The funds seek to

magnify the returns of their benchmarks on a daily

basis. Returns for longer periods are a product of

the daily leveraged returns during the period.

The following are a few examples of advisors and

investors that use Leveraged and inverse Leveraged ETFs

as a part of a well-diversified investment strategy.

Leveraged ETFs in action: Todd Bessey

Financial advisor Todd Bessey is a 15 year advisor, who

for the past seven years, has been working with affluent

clients at Wintrust Wealth Management in Algonquin,

IL, about 50 miles northwest of Chicago. By the end

of 2008, many of his moderate to aggressive risk client

portfolios had started to decline after several good years,

and he needed to find a way to add some value in a very

volatile market.

His had been looking at using leveraged energy ETFs

as a way to create some short term profits. He started

moving a select group of his clients into 20-30% cash,

and then began taking positions with 300% long funds.

That way, he could put the cash to work, generating

some alpha, and still get as much exposure as each

client wanted. Before long, he slowly expanded his new

strategy into technology, real estate, treasuries, and

emerging markets.

His strategy works like this: When he sees a trend he’s

comfortable with, he’ll pick an entry point, and then

gradually buy long leveraged ETFs in that market until

the market turns around, and then he gradually sells out.

It’s his own updated version of dollar-cost averaging;

adding a little value to the buy-and-hold approach. His

current clients who like his new strategy have referred

others, and now Bessey has about 30 clients in it. “We

only offer this strategy to clients who understand it,” he

says, “and whose risk profile it fits.”

It’s an approach that seems to be working. SSo far, he’s

closed out about 500 trades on ERX (300% energy bull

leveraged ETF) from January of 2009 through December

of 2011, and has made money on 87% of them.

21


“Everybody that’s been in our new strategy has been

very happy,” says Bessey. “Across our clients that have

participated, the average trade has generated a 13%

profit. In most cases, we are still holding another 10-

20% in cash reserve, so the clients had lower risk.”

Leveraged ETFs in action: Paul Ingersoll

Paul Ingersoll and his partners formed Good Harbor

Financial in Chicago in May 2003. Initially, they

conducted extensive research looking for an alternative

to the traditional buy-and-hold asset allocation strategy.

They concluded that asset prices aren’t driven by

projected cash flows, as many investors think: “We

believe that most changes in valuations come from

changes in the discount rate of those projected returns,”

Ingersoll says. “That risk premium changes over time.”

Consequently, the folks at Good Harbor spend their time

looking for leading indicators of where that discount rate

might go, and then adjusting their portfolios accordingly:

Their focus is primarily on economic data, changes in

interest rates, and the U.S. Treasury yield curve. They are

looking into the future a month, or two months at the

most.

Their research also revealed that a portfolio using

leverage would consistently outperform a static buy-

and-hold strategy with lower volatility (risk). In fact,

they found that the past 40 years of data shows the

optimal portfolio leverage to be 1.3 times. “If an investor

is comfortable with S&P risk,” he says, “then we can

generate more alpha.” To get that level of leverage,

they use separately managed client accounts that hold

a combination of leveraged and un-leveraged ETFs in

just the right proportions. “We couldn’t do what we do

without leveraged ETFs,” says Ingersoll. “We know what

we want, and ETFs work the way we expect.”

Their portfolios are tactical, based on their projections

of where the discount rates are going. They monitor

asset values on a day-to-day basis, but rebalance their

portfolios monthly. “We make big moves: 100% in

equities to 100% in fixed income,” he says. “The goal

of our strategy is to stay out of long, extended declines.

But how often do you react to data? Day-to-day has too

much noise, but if you wait too long, you miss good

information.”

Good Harbor Financial seems to have figured that out,

too. Their 5-year annualized returns are 13.9% vs.

0.25% for the S&P 500 Index. And since their inception

in May 2003, their portfolios are up 229.1% versus

the S&P’s 63.3%. “Recent markets have certainly

showcased our model,” says Ingersoll. “If we had tried

to market our story in 2006, we would have gotten

no attention. Our clients can opt out of our leveraged

portfolios, but investor’s rarely do.”

A Self-Directed Investor

A self-directed investor who works for a large financial

services company and prefers to remain anonymous has

been in the industry for nearly 15 years, spending some

of that time on a trading desk. Due to his experience and

market knowledge, he trades aggressively in his own

accounts. His strategy is primarily technical; watching

21-day, 63-day, and 120-day moving averages on the

sectors he follows. He uses leveraged ETFs and equities

to capture the opportunities he sees. “I like to keep

it simple and take the emotion out of investing,” he

explains. “I’m looking for convergences between the

moving averages, and tend to hold onto positions for

two or three months. During very volatile periods, such

as June through September of 2010, I’ll just hold the

position and have a stop limit.” His charts are always

running on his Thomson Reuters and Bloomberg feeds.

“I look at the charting every day,” he says. “And, when

they start to converge, I’ll get an alert in my email.”

22


He invests in some equities directly, but usually 65%

to 70% of his portfolio is in 3x leveraged ETFs: “I

want to capture the most profit,” he says. “I like the

diversification and the leverage. You never have to

worry about a margin call: Just sell, and you’re out.

And you can’t beat the expense ratios.” He uses large-

cap bull and bear funds, bull and bear energy and

financial funds, and a daily 7 to 10 Treasury bear fund.

“Sometimes I’m not even focused on which fund it is,”

he admits, “but when the moving averages on a given

symbol start to converge, then I make my move.”

High-Frequency Traders

There are some investment companies that are involved

in so-called high-volume trading activities. These

organizations—sometimes categorized as “high-

frequency traders”—make markets by trading both the

buy and the sell side of ETFs. These firms seek to profit

on their ability to identify and collapse any dislocations

in the premiums or discounts between the fair value of a

fund (based on the value of the underlying constituents

of the fund’s index) and the price of the fund’s shares

trading on the exchange.

What’s less understood is that these market makers

are not interested in exposing themselves to significant

market risk. They almost always offset a trade in one

direction with a hedge in the other. As market makers

seek to hedge their risk, they often trade the underlying

securities that make up an ETF’s index or other highly

correlated securities, such as futures and other ETFs.

For example, if a trader tried to buy $5 million dollars of

a 10-Year Treasury ETF and the market maker filled that

order without the existence of a corresponding seller,

the market maker would be short the 10-Year ETF. To

offset this short position, market makers typically buy

equal amounts of the underlying securities (10-Year

notes in this example) to hedge their position. If they

can easily buy those Treasury notes in the open market,

without impacting their underlying price, they will

minimize their market risk (offsetting short position in

the ETF, and long position in the underlying Treasuries).

To recap, the easier it is for a market maker to access

these underlying securities, the easier it will be for them

to hedge their short position, and the easier it will be for

them to facilitate liquidity in the secondary market. The

above example should illustrate that even if the trading

volume of an ETF is relatively low, an ETF may still be

liquid, as long as the underlying securities in the ETF can

be easily accessed as a hedge.

Their speed, and ability to hedge their risk, will ultimately

determine how tight they can keep the bid/ask spread.

Tight bid/ask spreads reduce the implicit cost of trading

and therefore improve liquidity in the ETF, which is

a benefit to all who trade it. The peripheral benefit

is an increase in liquidity across several securities.

Consequently, these market makers serve the dual

purpose of maintaining fair bid/ask spreads, while

ensuring that the ETF shares trade at or near to fair

value—the fund’s NAV. Thus, they play a crucial role in

the health of the markets for all ETFs.

High-frequency trader profile

One high-frequency trader who preferred to remain

anonymous works on the ETF trading desk of a large

hedge fund and asset management company. Part of

his job is to manage the volatility of the products his

firm and its investors are trading relative to their bid/

ask spread. He uses leveraged products, including

leverage ETFs, to help him do that. “We try to make

money on the spreads,” he says. “Leverage increases

our opportunity to do that. Leverage also enables us to

hold down our costs, to do it more cheaply than a typical

one-beta product.”

23


He also uses leveraged ETFs to help the firm’s clients

manage their portfolios. For instance, he uses them as

hedges on options positions: “Leveraged ETFs can be

cheaper than taking out an offsetting option; we’re

getting built-in financing.” Clients who are sector

rotating often want to get some additional sector

exposure, but they don’t want to sell out of what they

are already holding. “They can sell a portion of what

they currently hold,” he says, “and they use a leveraged

ETF to get the additional exposure they want.”

His firm’s asset managers also tend (sometimes

exclusively) to use a high percentage of leveraged

products in order to get more exposure in their portfolios

for less capital or to overcome rules they encounter

against shorting in certain situations. “They can usually

buy leveraged ETFs in these instances,” he says.

The trader also says that leveraged ETFs have improved

the markets he works in overall. “Leveraged ETFs have

added a new investment avenue, which reduces spreads

on cash and even on the tighter futures. Cash is a dollar

wide, futures are 10 cents wide. Now that we have more

points to trade on, there is more liquidity, which means

the betas will be tighter as well.”

Suitability

These user profiles illustrate clearly that there are several and varying uses for leveraged and inverse ETFs, but they are

certainly not for all investors. Investors who are considering using the funds should assess whether there is a reasonable

fit. The funds may generally be seen as a good choice for sophisticated, hands-on investors with:

• the willingness to accept substantial losses in short periods of time;

• an understanding of the unique nature and performance characteristics of funds which seek leveraged daily

investment results; and

• the time and attention to manage positions frequently to respond to changing market conditions and fund

performance.

Conversely, these strategies are probably not for investors who:

• cannot tolerate substantial or even complete losses in short periods of time,

• are unfamiliar with the unique nature and performance characteristics of funds which seek leveraged daily

investment results, and

• are unable to manage their portfolio actively and make changes as market conditions and fund performance dictate.

24


The Effects of Daily Rebalancing: The Key to Using Leveraged ETFs Effectively

In pursuit of their daily investment objectives (either 2x

or 3x a given index), leveraged ETFs must rebalance their

assets to the given exposure ratio on a daily basis. This

means that their returns, over time, are the product of a

series of daily returns, and not the fund’s beta multiplied

by the cumulative return of the index for periods greater

than a day. This variation in performance is commonly

referred to as compounding. The example below

illustrates that high volatility causes decay of long-term

returns for the funds, while sustained market trends can

result in positive effects on returns.

The Bottom Line: Monitor and Act When Necessary

Daily rebalancing funds are not meant to be held,

un-monitored, for long periods. If you intend to hold

leveraged ETFs for periods greater than a day, you must

always watch them closely, especially:

• during highly volatile periods for a fund’s

benchmark index, in which case you will need to

adjust your positions frequently if your goal is to

maintain constant exposure levels; and

• during periods of lower volatility for the benchmark

index, you should continue to monitor, but position

adjustments will likely be needed less frequently.

Leveraged ETF Myths

Despite the recent devastating market performance to

the contrary, more than a few investors—and financial

advisors—still believe that buy and hold is the only way

to manage investment portfolios. However, as we have

seen, many investment professionals, both institutional

and otherwise, have proven this untrue. Because markets

are not always efficient (hidden opportunities exist that

perform very differently than the broader markets),

smart investors take the time to find short- and medium-

term market trends and capitalize on them in ways

that those who only subscribe to long-term strategic

asset allocation methods repeatedly miss. Yet, because

leveraged ETFs were created to allow people to take

advantage of short-term opportunities, those who don’t

believe in these types of strategies would naturally not

understand their role, and therefore their advantages.

Consequently, due to the complexities of leveraged

ETFs—particularly the fact that they are rebalanced daily

(unlike traditional mutual funds or ETFs) and can either

benefit or suffer from the cumulative compounding

of an index’s gains or losses—there are many

misconceptions regarding these investment vehicles.

Here are some of the major misconceptions, along with

the facts.

Myth #1

The Funds Don’t Work: Shareholders are

disappointed because leveraged ETFs do not

provide returns through time, which are equal to

the fund’s target beta (200%, 300%, -200%, -300%)

times the cumulative return of the index.

While it is true that the funds do not necessarily provide

a return consistent with the cumulative return of the

index times the fund’s target multiple, this does not

mean that the funds don’t work. In fact, they have,

DayIndex Value

Index Daily Return

Index Cum. Return

Index Cum. Return 3x

3x Fund Daily Expected Return

Fund NAV

Actual Cum. Return

100 $20.00

1 95 -5.00% -5.00% -15.00% -15.00% $17.00 -15.00%

2 100 5.26% 0.00% 0.00% 15.78% $19.68 -1.60%

3 105 5.00% 5.00% 15.00% 15.00% $22.63 13.15%

4 100 -4.76% 0.00% 0.00% -14.28% $19.40 -3.00%

5 95 -5.00% -5.00% -15.00% -15.00% $16.49 -17.55%

6 100 5.26% 0.00% 0.00% 15.78% $19.09 -4.50%

25


at times, achieved their goals on a daily basis. Each

of the current leveraged index-based ETFs has a daily

investment objective, which means that the expected

returns for periods longer than a day is not the

product of: (a) the return of the benchmark for the

relevant period; or (b) the stated degree of the Fund’s

magnification.

In other words, if the Russell 1000® Index gains 5%

in a given month, an investor should not expect the

Direxion Large Cap Bull 3x Shares to gain 15% or the

Large Cap Bear 3x Shares to decline by 15% in that

same month. The returns of the funds for such longer

periods combine the product of the daily returns within

the period and the compounding that occurs over the

period because of the daily rebalancing, so it is therefore

dependent not only on the path of the underlying index

during the same period, but on the daily movements and

rebalances, which can therefore result in either more

or less than the cumulative return of the index for the

period.

The tremendous volumes of the leveraged ETFs, relative

to their shares outstanding, indicate that holding periods

are very short, meaning that the vast majority of users

are not confused about how the funds function or

should be used.

Daily leveraged funds have limited goals and functions,

but they can function as intended. These funds have

become extremely popular and are an invaluable

resource for any number of investors who manage their

portfolios actively and reject the long-only, buy-and-

hold investment strategies still touted by much of the

investment community.

Myth #2

Inverse (bear) ETFs cause downward pressure on

the markets.

People who make this argument sometimes sound as

though they would like to see an outright prohibition on

shorting. Perhaps this is not the case. As a fundamental

matter, it’s hard to understand the notion that shorting

harms the markets.

Healthy markets are designed to discover the proper

price levels for whatever is being traded. Most people

recognize that permitting short selling simply adds

robustness to price discovery. Those in favor of banning

shorts entirely are trying to manage the market higher

by silencing one side of the argument. This is generally

self-defeating and harmful in anything but the very short

term.

The recent housing bubble was caused at least in part

because it is so difficult to short housing. This illustrates

the danger of one-way markets.

While it would seem logical to believe that markets are

most efficient if they are two-way, and that shorting

should be permitted, it is also important to support the

belief of those who feel that market manipulation—

“Bear Raids”—should be stopped and that the

practitioners should be uncovered. At this time it is

unknown how extensively “Bear Raids” by hedge funds

have occurred, but the sponsors of leveraged ETFs are

usually market-agnostic and would generally try to point

out that the use of an index product to conduct a “Bear

Raid” on an individual name would be very inefficient.

Myth #3

Leveraged ETFs allow people to get around margin

rules.

This criticism seems to imply that margin rules were

designed to protect investors by limiting the risk profile

of their holdings. This is not the case at all. There are

two separate margin rules: 1) limits on borrowing in

taxable accounts; and 2) prohibitions on borrowing and

26


shorting in tax-exempt accounts. The rules that apply

to taxable accounts were put in place to protect banks

and brokers from the loss of their clients. They were not

designed as investor protection rules.

Leveraged ETFs are risky, as is noted in all the literature.

However, they do not pose risks to the brokerage

firms because an investor cannot lose more than their

initial investment. The margin rules that apply to tax-

exempt accounts were put in place primarily to prevent

fiduciaries from engaging in transactions with implicit

conflicts of interest with accounts over which they have

fiduciary authority. The rules essentially prohibit certain

behavior between the fiduciary and the account holder.

The use of leveraged ETFs essentially prohibits certain

behavior between the fiduciary and the account holder.

The argument against the funds based on evasion of

margin rules imbues the margin rules with an intent that

is simply not there.

Myth #4

Leveraged ETFs exacerbate market volatility at the

end of the trading day.

At the end of the day, leveraged ETFs are market

participants that serve to: (a) respond to creations/

redemptions; and (b) to rebalance in light of market

movements. The first activity has no material impact

on the market at or near the close, while the second

activity might essentially prohibit certain behavior

between a fiduciary and the account holder. The use

of unaffiliated leveraged ETFs does not implicate those

concerns either.

Creations and Redemptions: When there is natural

demand for an ETF, the market maker sells more shares

of the ETF than he has in inventory and builds a short

position in the ETF. Concurrently, the market maker

creates a hedge by, for example, buying a basket of the

index’s underlying securities with the equal notional

value to assure that the short position will have limited

economic impact on the market maker. At the end of

the day, the market maker goes to the ETF sponsor and

buys ETF shares through the creation process to cover

his short position in the ETF. At the close, the sponsor

spends that money to create the required number of

ETFs and the market maker unwinds his hedge since he

will receive the ETFs at that night’s closing price. These

two transactions are offsetting, and have no net impact

on the markets. (In the one beta [non-leveraged], in-

kind ETF world, the market maker delivers the hedge—

the basket of underlying equities—to the sponsor,

which makes the lack of market impact perfectly clear.)

Daily Rebalancing: The trading activities related to

rebalancing leveraged funds can theoretically have an

impact on the markets because bull and bear funds

rebalance in the same direction and in a direction

consistent with the daily movement of their benchmark.

For example, when the benchmark rises, the bull fund

assets rise and the bull fund buys to increase exposure,

while bear fund assets decline and the bear fund buys

to decrease short exposure. Conversely, when the

benchmark declines, the bull fund assets decline and

bull fund sells to decrease long exposure, while the

bear fund assets rise and bear fund sells to increase

short exposure. Theoretically, it is possible that this

rebalancing activity impacts the markets in the last

hour or half-hour of the day. Practically, at this point,

the trading volume attributed to leveraged ETFs in the

last half-hour of the trading day is small relative to the

overall markets and so it seems unlikely. (Credit Suisse’s

Victor Lin cited this in his recent paper “Leveraged ETF

Rebalancing in Perspective” from August 2011.)

More importantly, however, rebalancing activity is very

transparent. The net asset value and number of shares

outstanding of each ETF is public information. Market

27


participants know exactly what an ETF needs to do each

day given market movements and such participants can,

and do, try to arbitrage these trades, just like they do for

other events about which they have forewarning, like

index rebalances, Market on Close (MOC) imbalances,

forced asset allocation rebalances, etc. The fact that

arbitrage is occurring seems to be borne out by the facts.

If you believe that the leveraged ETFs have an impact

on the market, you would expect the market direction

after 3:00 p.m. Eastern Time to confirm the direction

until 3:00 p.m. (You would expect a declining market to

get worse as the leveraged index funds sell into it and

a rising market to get even more carried away as the

leveraged index funds buy in response to market gains.)

However, there is no empirical evidence that the market

is following through any more than 50% to 60% of the

time, depending on the particular index. If the funds

are big enough to have an impact, that impact seems to

have been understood and internalized by the markets.

Conclusion

Today, more than ever, it’s essential for retail investors

and financial advisors to fully understand the investment

vehicles in their portfolios. While more and more

financial professionals and industry analysts these days

are touting the virtues of alternative investments, not

all types are created equal. Risk parameters can differ,

time horizons can vary, and in the case of leveraged

ETFs, daily rebalancing can change the effects of

compounding. Some alternative investment vehicles

require active monitoring and management, while others

employ a managed strategy that provides buy-and-hold

investors access to the category. Misunderstandings

about these investments, particularly leveraged ETFs,

have led to many myths in the media and popular

culture. To set the record straight:

• Leveraged ETFs are designed to meet daily

investment objectives (based on a multiple of the

underlying index), not to provide compounding of

returns beyond one day (as is commonly the case in

buy-and-hold investing);

• Most alternative investment vehicles, particularly

those involving leverage, actually help to identify

market inefficiencies more quickly and therefore

increase market efficiency;

• Leveraged ETFs actually provide a valuable benefit

by allowing investors the ability to take short

positions without having to be subjected to losses

greater than their principal investments, as is the

case with margin accounts; and

• There is no evidence that leveraged ETFs change

the market directions when they rebalance their

positions after 3:00 p.m. on trading days.

The bottom line is that, like Mary Shelly’s Frankenstein

monster, because alternative investments and leveraged

ETFs are different from traditional investment vehicles,

they are widely misunderstood and criticized, while the

truth is that they are beneficial, both to their investors

and to the markets as a whole. For investors and

advisors who use today’s alternative investment products

as they are intended, the effects on their portfolios can

be quite dramatic. The additional asset classes they

offer (including commodities, currencies, and debt),

along with short positions, hedging, and leverage, are

all tools that sophisticated investors have used very

effectively for many years. The difference is that now, for

retail investors and most financial advisors, there are a

number of vehicles that offer access to these strategies,

including alternative mutual funds, passive ETFs, futures

and options, and index leveraged and inverse-leveraged

mutual funds and ETFs—and a growing number of retail

investors and investment advisors are using them.

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A new perspective on investing

Financial advisors have been preaching the

commandments of diversification and asset allocation to

their clients for decades. Today, in hindsight, reality may

cause many to consider a more active solution. The fact

is that investment markets have changed—experiencing

higher volatility, especially during certain periods, and

increased correlation levels across asset classes. This was

especially evident over the past 10 years, the so-called

Lost Decade, which ended with the Market Meltdown.

Those who benefited over the decade were those who

used investment vehicles that sought returns from short-

term market trends. Institutional investors and hedge

funds have been utilizing these strategies with a high

degree of success for several decades.

Thanks to several innovative product developments in

recent years in the “40 Act” mutual fund and ETF space,

today’s investors—and financial advisors—have increased

access to similar strategies. Although we are in the

early stages of this product democratization, broader

access to these sophisticated strategies has proven to be

very beneficial to the broader investment community,

particularly for those investors who realize the limitations

of the “buy-and-hold” approach in today’s challenging

investment environment.

29


Glossary of Terms:

Beta

A measure of the systematic variability of a security or a portfolio in relation to a target index. A beta of more than 1.00

indicates that the security or portfolio would have higher volatility than the index; a beta of less than 1.00 indicates lower

volatility.

Alternative Investment

An investment that is not one of the three traditional asset types (stocks, bonds and cash). Most alternative investment assets

are held by institutional investors or accredited, high-net-worth individuals because of their complex nature, limited regula-

tions and relative lack of liquidity. Alternative investments include hedge funds, managed futures, real estate, commodities

and derivatives contracts.

Asset AllocationAn investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s

goals, risk tolerance and investment horizon.

Derivative

A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a

contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common

underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are

characterized by high leverage.

Leverage

The use of various financial instruments or borrowed capital, such as margin, to increase the potential return of an investment.

Hedge

Making an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an

offsetting position in a related security, such as a futures contract.

Absolute Return

The return that an asset achieves over a certain period of time. This measure looks at the appreciation or depreciation (ex-

pressed as a percentage) that an asset - usually a stock or a mutual fund - achieves over a given period of time.

Long/Short Strategy

A hedge fund strategy that involves buying certain stocks long and selling others short. There usually isn’t a restriction on the

country that the stocks trade in either.

30


Currencies

A generally accepted form of money, including coins and paper notes, which is issued by a government and circulated within

an economy. Used as a medium of exchange for goods and services, currency is the basis of trade.

Commodities

Seeks to achieve capital appreciation through investment in various commodities, such as energy, livestock, metals, and other

commodities.

REITs

A security that sells like a stock on the major exchanges and invests in real estate directly, either through properties or mort-

gages. REITs receive special tax considerations and typically offer investors high yields, as well as a highly liquid method of

investing in real estate.

Correlation

In the world of finance, a statistical measure of how two securities move in relation to each other. Correlations are used in

advanced portfolio management.

Sub-prime Meltdown

A financial crisis that arose in the mortgage market after a sharp increase in mortgage foreclosures, mainly subprime, col-

lapsed numerous mortgage lenders and hedge funds.

Volatility

A statistical measure of the dispersion of returns for a given security or market index.

Managed Futures

Seeks to capitalize on market trends through investment in a variety of futures and options contracts.

Compounding

The ability of an asset to generate earnings, which are then reinvested in order to generate their own earnings. In other

words, compounding refers to generating earnings from previous earnings.

Risk Management

The process of identification, analysis and either acceptance or mitigation of uncertainty in investment decision-making. Es-

sentially, risk management occurs anytime an investor or fund manager analyzes and attempts to quantify the potential for

losses in an investment and then takes the appropriate action (or inaction) given their investment objectives and risk tolerance.

Inadequate risk management can result in severe consequences for companies as well as individuals.

31


S&P 500

An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to

be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.

The S&P GSCI

A composite index of commodity sector returns which represents a broadly diversified, unleveraged, long-only position in

commodity futures. The S&P indexes are trademarks of Standard and Poor’s, a division of the McGraw Hill Companies, Inc.

The Russell 2000

An index measuring the performance of the 2,000 smallest companies in the Russell 3000 Index, which is made up of 3,000 of

the biggest U.S. stocks. The Russell 2000 serves as a benchmark for small cap stocks in the United States. The Russell Indexes

noted herein are trademarks of Russell Investments. These funds are not sponsored, endorsed, sold or promoted by Russell

Investments and Russell Investments makes no representation regarding the advisability of investing in the funds.

MSCI EAFE

An index created by Morgan Stanley Capital International (MSCI) that serves as a benchmark of the performance in major

international equity markets as represented by 21 major MSCI indexes from Europe, Australia and Southeast Asia. This

international index has been in existence for more than 30 years.

MSCI EM

An index created by Morgan Stanley Capital International (MSCI) that is designed to measure equity market performance in

global emerging markets. MSCI indexes are the exclusive property of MSCI and its affiliates. All rights reserved. Indexes are

unmanaged and cannot be invested in directly.

The DJIA

A price-weighted average of 30 significant stocks traded on the New York Stock Exchange and the Nasdaq. The DJ-UBS

Commodity is composed of futures contracts on physical commodities.

The CTI and FXTI

Long/Short Indices of commodities and financial futures.

The BarCap US Aggregate Bond Index

An index used by bond funds as a benchmark to measure their relative performance.

32


Standard Deviation

In Finance, standard deviation is applied to the annual rate of return of an investment to measure the investment’s volatility.

Standard deviation is also known as historical volatility and is used by investors as a gauge for the amount of expected volatil-

ity.

Alpha

A measure of performance on a risk-adjusted basis. Alpha takes the volatility (price risk) of a mutual fund and compares its

risk-adjusted performance to a benchmark index. The excess return of the fund relative to the return of the benchmark index

is a fund’s alpha.

FTSE 100

The FTSE is similar to Standard & Poor’s in the United States. They are best known for the FTSE 100, an index of blue-chip

stocks on the London Stock Exchange.

NASDAQ 100 Index

An index composed of the 100 largest, most actively traded U.S companies listed on the Nasdaq stock exchange. This index

includes companies from a broad range of industries with the exception of those that operate in the financial industry, such

as banks and investment companies.

Volatility

A statistical measure of the dispersion of returns for a given security or market index. Volatility can either be measured by

using the standard deviation or variance between returns from that same security or market index. Commonly, the higher the

volatility, the riskier the security.

Arbitrage

The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by

exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage

exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value

for long periods of time.

Futures

Financial contracts obligating the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a

financial instrument, at a predetermined future date and price. Futures contracts detail the quality and quantity of the underly-

ing asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical deliv-

ery of the asset, while others are settled in cash. The futures markets are characterized by the ability to use very high leverage

relative to stock markets.

33


Options

Financial derivatives that represents a contract sold by one party (option writer) to another party (option holder). The contract

offers the buyer the right, but not the obligation, to buy (call) or sell (put) a security or other financial asset at an agreed-upon

price (the strike price) during a certain period of time or on a specific date (exercise date).

Derivative

A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a con-

tract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underly-

ing assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized

by high leverage.

Drawdown

The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually

quoted as the percentage between the peak and the trough.

Swap

Traditionally, the exchange of one security for another to change the maturity (bonds), quality of issues (stocks or bonds), or

because investment objectives have changed. Recently, swaps have grown to include currency swaps and interest rate swaps.

Dollar Cost Averaging

The technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price.

More shares are purchased when prices are low, and fewer shares are bought when prices are high.

Merger

The combining of two or more companies, generally by offering the stockholders of one company securities in the acquiring

company in exchange for the surrender of their stock.

Documents

The Lost Decade