Leveraged funds are a class of mutual fund that are designed to multiply the returns of an underlying index or asset class using financial derivatives and debt. These funds aim to achieve a return that is a multiple of the benchmark they track such as 2x or 3x the daily performance. They can offer potentially higher returns than traditional funds by leveraging borrowed capital. However, the increased exposure also comes with greater risks that make leveraged funds suitable primarily for experienced investors. Any investor looking for such an investment strategy should first understand what are leveraged funds, how leveraged funds work and all the related potential benefits and risks.

Leveraged funds are investment vehicles that amplify their potential returns by using financial derivatives and borrowed capital. These funds try to increase the exposure to some underlying index or asset in such a way that investors could realise potentially very high returns compared to those offered by traditional investment funds. In other words, by borrowing capital, leveraged funds can enormously inflate the market positions. However, by doing this, the risk also subsequently increases. The very mechanism that amplifies gains can also amplify losses, making leveraged funds a rather high risk option. These funds are generally used by trained investors looking to benefit from short-term market swings. Moreover since leveraged funds are complex and at the same time carry greater risks, it is of prime importance that any investor be adequately knowledgeable about market dynamics and have strong risk tolerance before investing.

Now that the leveraged funds meaning is clear to you, let us discuss how such funds work. Leveraged funds work by using borrowed capital or financial derivatives, such as futures and options, to amplify the returns of an underlying index or asset. The idea is to increase the prospective gain through leverage that gives a larger exposure to the movements in the market. For instance, a 2x leveraged fund is supposed to double the daily return that the benchmark index produces. If the index rises 1%, the fund should rise 2%. This principle, however, also holds true for losses so if the index is down 1%, then the fund could lose 2%.

These funds are for short-term trading and get rebalanced every day to track the expected leverage ratio. Although this kind of daily rebalancing would keep the fund's performance most consonant with its intended target, it can also cause compounding effects that may produce unexpected results over time. This means that one should not usually expect a leveraged fund to be appropriate for holding long-term investments since the daily changes, when repackaged, can be far away from what might be expected. You should bear in mind the fact that leveraged funds are quite risky and that you have to establish appropriate market strategies before investing in them.

Leveraged funds offer the potential for higher returns by amplifying the performance of the underlying index or asset. They allow investors to gain exposure to market movements without requiring the same amount of capital. These funds are also cost-effective, as they eliminate the need for individual stock picking and frequent trading. Additionally, leveraged funds provide a convenient way for investors to take advantage of short-term market trends with the ease of trading like a traditional fund. Here are a few of its major benefits:

Ease of tracking the index

Leveraged funds are designed to track the index and hence its fund performance can easily be derived. An investor can derive the fund performance by simply tracking the underlying index without the headaches of analysing individual stocks. This makes tracking easier, especially for short-term traders, where one needs to determine how the fund is going to react rapidly to the index changes that are underway.

High returns regardless of investment size

Leveraged funds provide the opportunity for substantial returns even with a relatively small investment. By using leverage, these funds can magnify gains that allows investors to achieve significant returns without committing large amounts of capital. This feature of leveraged funds becomes very attractive for those whose goals are aggressive in multiplying assets within a very short period but at a cost of higher risk.

Absence of per-trade transaction expense

One advantage with leveraged funds is that there are no per-trade transaction costs passed onto the investor. Trading leveraged funds calls for no limitation from any transaction costs, which is not the same in other investment types, where a fee has to be paid for every transaction made on direct stock trade investments. These make leveraged funds cost efficient because an investor can enter and exit leveraged funds as often as one pleases without occurring very high transaction costs.

Cost-effectiveness

Leveraged funds are generally more cost-effective compared to individually leveraged positions. By pooling resources, these funds reduce the overall cost of leveraging and allow investors to gain magnified exposure to an index without the need for personal capital or complicated financial setups. This cost efficiency is attractive to those looking to optimise their investment strategy.

Diversification

Leveraged funds offer built-in diversification by spreading investments across multiple assets within an index. This helps to mitigate the risk associated with investing in individual stocks while still providing the potential for amplified returns. Diversification within leveraged funds can be particularly advantageous for investors seeking to balance risk and return in a high risk investment strategy.

Leveraged funds come in various types, each designed to target specific markets or investment strategies. These include money market funds, equity funds, index funds, balanced funds, and bond funds. Each type offers different risk and return profiles that allow you to choose a leveraged fund that aligns with their investment goals and risk tolerance. Know more about these types in the paragraphs below:

Money market funds

Leverage money market funds concentrate their investment in short term, very high-quality debt securities, such as Treasury bills and commercial paper. Such funds resort to borrowing with the primary objective of trying to boost returns as they have slightly higher yields compared to a plain money market fund. Moreover, they are of lower risk compared to other types of leveraged funds, though introducing leverage still can result in large risks, especially within volatile markets. These funds are often picked by investors seeking a relatively conservative investment with enhanced return potential. However, it is important to note that because of their leveraged nature, even small changes in the underlying market can result in outsized gains or losses.

Equity funds

Leveraged equity funds focus on investing in stocks, using leverage to boost the potential returns. These funds are designed for investors who wish to capitalise on the fluctuations in the stock market. They offer their investors an amplitude of movements in an equity index or a basket of stocks to enable them to have the chance of higher returns compared to a non-leveraged equity fund. However, the risks are also much greater because of this inherent volatility in the stock market. Compounding effects from the daily rebalancing of a leveraged equity fund may depart significantly from its expected returns over time. This makes the leveraged equity funds only suitable for short-term investors who have the time to closely follow market movements.

Index funds

Leveraged index funds try to multiply the return on a particular underlying index, like the Sensex or the Nifty 50. Such funds use financial derivatives to obtain returns that are a multiple, normally 2x or 3x, of the index's daily performance, making them quite popular among traders who seek to gain from short-term movements in the market. While the daily rebalance can be done to maintain the leverage ratio, over longer periods, compounding effects might result in a divergence of the fund's performance from the index. Such funds do offer maximum possible gains, yet, they are also extremely risky and are therefore more apt for the experienced investors who can fathom the intricacies of leveraged trading.

Balanced funds

Leveraged balanced funds combine stocks and fixed-income investments in a single portfolio with the view of achieving a proper balance between potential growth and stability. These funds utilise leverage to amplify the returns from both asset classes, offering a more diversified approach to investing. These funds pit the potentially high growth of equities against the relative stability of bonds with an objective to handle risk while still presenting the opportunity for enhanced returns. However, leverage increases the overall level of risk, since losses can be multiplied to the same degree as gains. Many investors seeking only moderate risk therefore use balanced funds to take advantage of possibly higher returns but be aware of the additional risks introduced by leveraging.

Bond funds

Leveraged bond funds invest in a variety of fixed-income securities, including government and corporate bonds, with the aim of boosting returns through leverage. These funds are generally considered less risky than leveraged equity funds, as bonds tend to be more stable. However, they are still subject to interest rate risk and credit risk, which can be exacerbated by the use of leverage. Investors in leveraged bond funds should be aware that while these funds offer the potential for higher returns, they also carry the risk of amplified losses. These funds are suitable for those who seek to enhance their income from bond investments but are willing to accept the additional risks associated with leverage.

• Leveraged funds can significantly increase potential losses just as it can magnify gains. This can lead to severe financial risks, especially in volatile markets.
• Leveraged funds are rebalanced daily, which can result in a compounding effect. Over time, this can cause the fund's performance to deviate from the expected multiple.
• These funds are highly volatile and are best suited for experienced investors who have a high tolerance for risk. The potential for quick gains is matched by the potential for equally rapid losses.
• Leveraged funds involve borrowing capital which comes with associated costs. These borrowing costs can gradually erode the overall returns of the fund particularly in a low-return environment.
• These type of funds are extremely sensitive to market conditions. A sudden downturn can lead to significant and rapid losses, making these funds a risky option for most investors.
• Due to the daily rebalancing and compounding effects leveraged funds are generally not suitable for long-term investments. 

Leveraged funds  are a type of investment option that can deliver high returns by magnifying the performance of an underlying index or asset. However, they also carry great risks such as amplified losses and high volatility. These funds are generally suited for experienced investors who know the market dynamics and possess a high risk tolerance. Effective planning and a thorough grasp of how leveraged funds work are crucial to leveraging their benefits while managing risks. Consulting with a financial advisor is advisable before choosing to invest in leveraged funds. For better investment planning, make use of tools like a Mutual Fund Calculator and always compare mutual funds to find the best options. Explore the Bajaj Finserv Platform to access over 1,000 mutual fund schemes before investing in mutual funds of any kind and manage your investments effectively.