Leverage Can Produce Unexpected Returns Exchange-traded funds that use leverage are proof positive why investors need to read the fine print. Many of these funds promise to deliver twice the return of an underlying stock or bond index -- or move twice as much in the opposite direction. So with the Standard & Poor's 500-stock index down 38.5% in 2008, a double-leveraged fund designed to profit when the S&P 500 falls would be up 77%, right? The Journal Report See the largest stock funds and bond funds and also how fund categories stack up. Plus, see funds quotes, listed A-Z by family. The complete Investing in Funds: A Quarterly Analysis report.Wrong. The UltraShort S&P500 ProShares rose 61%. Even more confusing, the ProShares fund designed to return twice the opposite of the Dow Jones U.S. Real Estate Index was down 50% for 2008, while the index was also down, by 43%. The issue is that these funds are designed to double the index's return -- or double the inverse of that return -- on a daily basis. The compounding of those daily moves can result in longer-term returns that have a very different relationship to the longer-term returns of the underlying index. For example, take a double-leveraged fund with a net asset value of $100. It tracks an index that starts at 100 and that goes up 5% one day and then falls 10% the next day. Over that two-day period, the index falls 5.5% (climbing to 105, and then falling to 94.5). While an investor might expect the fund to fall by twice as much, or 11%, over that two-day period, it actually falls further -- 12%. Here's why: On the first day, doubling the index's 5% gain pushes the fund's NAV to $110. Then, the next day, when the index falls 10%, the fund NAV drops 20%, to $88. The effect of compounding results in greater distortions when there are big up and down swings in the market. That's the reason the real-estate index and its double-inverse ETF were both down over the course of last year. For the most part, these funds are used by short-term traders. But they're gaining traction among individual investors who use them as a hedge in a portfolio. That's where these distortions cause real trouble. Take an investor who on Oct. 10 wanted to offset a $100,000 investment in an S&P 500 index fund by putting $50,000 in the UltraShort S&P500 ProShares. Two months later, despite big back and forth swings, the S&P 500 was pretty much unchanged. But that ETF was actually down 24% in that time frame, leaving the investor with a $12,000 loss. To ProShares' credit, warnings about the disparity between daily and long-term returns are spelled out in the materials for the funds and on the firm's Web site. "We try to get the concept out to people," says Michael Sapir, chief executive of ProShares. "It's just a feature of this kind of investing."