Dollar General’s price per share has to go up to $670.44 from the current share price of $32.19 for Berkshire Hathaway’s Dollar General Holdings to have a 1% positive performance impact on the overall portfolio. By the same token Kraft’s price per share only needs to go up from $34.68 to $46.07 to have the same impact. To summarize, the CNN articles’ premise is completely misleading - the portfolio adjustments in the second quarter 2011 are very minor compared to the overall portfolio size to warrant any such judgment call. Furthermore, Berkshire Hathaway’s 2nd quarter 2011 adjustments may have nothing to do with Warren Buffet’s stock selection. It is highly likely that the Dollar General (DG) pick was by Todd Combs, the hedge fund manager Buffet tapped in late 2010, as the amount involved is comparatively little. While the article by CNN Money did a disservice to the investing community, articles from Bloomberg and Morningstar did convey reputable information. Readers can also find the information by comparing Berkshire Hathaway’s latest 13F SEC filing with their previous filing.

 

The 300% leverage is achieved by using futures contracts and swap contracts. Below is a look at how the expenses associated with leverage affects the overall performance (taken from Direxion leveraged fund introduction sheet):



The expected return sample assumes a benchmark return of 2% for the bull fund and a -2% return for the bear fund. As shown, the impact of expenses is minimal on a daily basis – in fact, for the bear fund, there is investment income associated with creating the leverage as opposed to an expense for the bull fund because, the bear fund uses short-selling which realizes income that can be invested to produce daily income.

The question to help figure out the risk associated with the leverage is: What happens to an investment in one of these funds (either bull or bear), if the associated index goes up more than 33.34% one day and follows it up with a 33.34% down day? – The answer is that your investment will go to zero – the up-day will wipe out the bear fund while the down-day will wipe out the bull fund. Such an outcome is unlikely but helps demonstrate the fact that in volatile markets that lack direction, these investment options can lose value very quickly. A more realistic example in a market that lacks direction using FAS and FAZ and assuming FAS and FAZ along with the associated index value is all at 100 at the start of the first trading day:



So, over the course of just 4-days, there is an underperformance - FAS should have been at 113.23 and FAZ should have been at 86.77. Another example that uses FAS and the same assumptions in a market that is in a steady up-trend follows:



In this scenario, there is an outperformance when compared to the target index value at the end of the fourth day – FAS should have been 144.16 and FAZ should have been at 55.84. Similar outperformance exists in a steady down-market as well.

Summary:

It is critical to understand the use of leverage and how it impacts the performance of the funds over a period of time. Since these funds track the performance of the associated index at 3 X (or inverse) leverage on a DAILY basis, it is not possible to mimic the performance of the associated index over a period of time. As the latter spreadsheets indicate, if one can guess the market direction correctly, the funds can provide outperformance over the period of time anticipated. Conversely, in a market that lacks direction, these funds are unsuitable.

The legitimate question that begs is if one can get 3X leverage using these funds, why not funds that have leverage 5X, 10X, 100X, etc. Presumably, one can strike gold overnight by guessing the market direction correctly for a single day by holding a 100X leveraged fund. While the advantage is undeniable, technically it is impossible to increase leverage much further – margin requirements limit the amount of leverage possible. A commonly overlooked factor is that the chances of these funds going to zero over a short period of time increases as the leverage increases. Looking at the performance of FAZ/FAZ since its inception should make this pretty obvious - both these indexes show large negative returns over the few years since inception, indicating a strong possibility of both going to zero eventually.

We have nibbled a few times on FAS/FAZ on a short-term basis realizing small profits. Our opinion is that these products are suitable for the following scenarios:

1. The benchmark index is at extremely overbought levels. Entering the bear-funds at such levels should prove beneficial over the short-term (a few days).
2. The benchmark index is at extremely oversold levels. Entering the bull-funds at such levels should prove beneficial over the short-term (a few days).
3. You anticipate a steady bull/bear market for the benchmark index. Entering the bull/bear funds during such market conditions should prove beneficial over the anticipated period (longer term).
4. Day trading – when the benchmark index is extremely volatile, there is an opportunity to do roundtrips to realize small profits (intra-day).

Because of the leverage and associated risks, the above strategies should only be used with small portions of your overall portfolio. But, the risk-reward ratio is good assuming your strategies are sound and comfortable to work with.