# Components of Geared Funds

Leveraged and inverse funds, also called "geared" funds, seek to return a multiple or inverse multiple (e.g., 2x, -2x) of the return of a benchmark for a single day, before fees and expenses. There are a number of ways geared funds can be constructed to achieve their objectives, including using combinations of traditional securities, like equities and cash, along with derivative products, such as futures, forwards and swaps.

## What Are Derivatives?

Derivatives are financial instruments that change value in relation to an underlying asset without investing in the asset itself. Futures, forwards and swaps, for example, are investment contracts between parties to buy, sell or exchange assets like equities, commodities, currencies or loan terms at agreed-upon prices. They make or lose money depending on whether market prices are greater or less than the contract prices for the underlying assets. Cash flows are calculated relative to a particular “notional amount,” or the face amount of the financial instrument. Some derivatives are subject to counterparty risk—the risk that a counterparty defaults on a payment due—and other risks.

## Constructing Sample Leveraged and Inverse S&P 500 Funds

Consider these S&P 500 funds, one leveraged and one inverse, each with $100 million in assets. To generate 2x or -2x exposure, each fund must invest in a combination of equities and S&P 500-related derivatives with total exposures of $200 million, long or short.

## S&P 500 Long Fund

*For illustrative purposes only. This example shows just one method for creating 2x exposure to an index and does not represent the investment components of an actual fund.*

- The long fund might invest 85% of its underlying assets in S&P 500 stocks. The remainder of the assets (15%) would remain in cash.
- The fund might then use a portion of its cash to purchase S&P 500 futures contracts—enough to provide $25 million of index exposure. This would bring the portfolio's index exposure to 110%.
- The fund might also employ long equity index swap agreements tied to the S&P 500, with a notional value of $90 million. The fund would receive the index's total return on the $90 million notional value in return for interest payments on the same amount. The index return (positive or negative) and the interest payments would be accounted for on a daily basis.

## S&P 500 Short Fund

*For illustrative purposes only. This example shows just one method for creating -2x exposure to an index and does not represent the investment components of an actual fund.*

- The short fund might keep nearly all of its assets in cash.
- The fund might then use some of its cash to open short positions on S&P 500 futures contracts—enough to provide about 30% of inverse index exposure.
- The fund might also employ short equity index swap agreements tied to the S&P 500 with a notional value of $170 million. The fund pays the index's total return on the $170 million notional value and receives interest payments on the same amount. The index return (positive or negative) and the interest payments would be accounted for on a daily basis.

Leveraged and inverse investing is not for everyone. Geared funds are generally riskier than funds without leveraged or inverse exposure. Before investing, read each fund’s prospectus to fully understand all the risks and benefits. For more information on using geared funds, read GEARED INVESTING: An Introduction to Leveraged and Inverse Funds.