Should You Own a Bear-Market Fund?

These funds are looking awfully tempting lately, but watch out.

There's no doubt about it--the past year has been brutal for the stock market. All the major market indexes are down around 40% from their October 2007 peaks. With fallout from the mortgage crisis ensnaring huge financial institutions, credit remaining extremely tight, and the United States economy almost certainly in a recession, pessimism has been the order of the day for investors.

Not surprisingly, equity mutual funds have been hit hard by all this gloom and doom, with nearly all Morningstar categories deep in the red in 2008. One of the few exceptions is the bear-market category, which has been putting up some head-turning numbers. As of Oct. 10, the average fund in the category was up a whopping 69% for the year to date. No other category has fared better. Some individual bear-market funds are actually up triple digits this year.

Seeing returns like that, you might be wondering whether a bear-market fund is worth looking into right about now. If so, take a deep breath and count to 10, because a bear fund is probably not a good idea. Bear-market funds tend to attract lots of attention after the market has tanked, as it has recently, but that's usually one of the worst times to buy them. These funds can have some value in certain circumstances, but trying to use them to time the market and benefit from market slides is a dangerous game.

How Bear-Market Funds Work

Before we get into the finer points of using bear-market funds, it will be helpful to go over exactly what these funds are and how they work. Specific tactics vary, but in a nutshell, they're designed to do the opposite of whatever the market does: If the market goes down, bear-market funds go up, and vice versa. The "market" in this context generally means some index such as the S&P 500 or the Nasdaq 100, though there are also some more narrowly focused equity bear funds, such as ProFunds Short Oil & Gas (SNPIX) or ProFunds UltraShort Japan (UKPIX) and some based on bond indexes, such as Direxion High Yield Bear (PHBRX).

Bear funds typically achieve their returns by short-selling index futures. Short-selling involves selling a borrowed security in the hopes that its price will go down; if it does, the short-seller can buy the security back at a lower price and thus make a profit. (The flip side is that if the price goes up, the short-seller will lose money.) An index future is a type of derivative that tracks the performance of an index but can be bought and sold like a stock--and also sold short like a stock. By short-selling futures of a given index, a bear-market fund can achieve the inverse of that index's returns; thus, if the index goes down 1% on a given day, a bear fund tied to that index should go up 1%, and vice versa.

As if that weren't complicated enough, some bear-market funds use leverage (essentially, borrowing assets to buy more securities) to return 2.0 or 2.5 times the inverse of their chosen index, thus magnifying both the potential upside and downside returns. Rydex Inverse S&P 500 2x Strategy (RYTPX), for example, is designed to return twice the inverse of the S&P 500's return each day; thus, if the S&P 500 loses 2%, this fund is supposed to gain 4%. And while most of the bear-market category consists of index funds, there are also a couple of actively managed funds of this type: Prudent Bear (BEARX) (the largest bear fund, with $1.1 billion in assets) and Grizzly Short (GRZZX). These short not just index futures, but also individual stocks that the managers think are due for a fall. Prudent Bear also holds long positions in some stocks that tend to do well in tough economic times, such as gold-mining stocks.

What They're Good For

Given how they work, it shouldn't be any surprise that most bear-market funds have done very well amid the tanking stock market of the past year. The best performers of the bunch have been leveraged bear-market funds that return twice or 2.5 times the inverse of the Nasdaq 100, an index full of technology stocks that have taken a beating this year. For example, Direxion NASDAQ-100 Bear 2.5x (DXQSX) has gained 157% for the year to date through Oct. 10 and ProFunds UltraShort NASDAQ-100 (USPIX) has gained 47%. More than a dozen other bear-market mutual funds have gained at least 20% this year, and virtually all of the stock-oriented bear funds have double-digit gains.

Those returns may look impressive, but they come at the cost of very high volatility--and big losses when the market is on an upswing. The same funds now riding high were posting big losses in 2007; Direxion NASDAQ-100 Bear 2.5x was down 36%, and ProFunds UltraShort NASDAQ-100 was down 28%. That's not an isolated instance, either; over the trailing five years, during most of which the market was going up, the ProFunds fund has generated an annualized loss of 22%, including a staggering 63% loss in 2003. Other bear-market funds have also posted losses during the same period, albeit not as dramatic.

If you buy one of these funds now, you're essentially betting that the market will continue to go down significantly. But such market-timing bets are extremely risky and have burned many investors in the past. In fact, the times when investors are most pessimistic (and thus most interested in bear-market bets) often correspond to market bottoms, just before the market starts to go up again.

Tread With Caution

For all these reasons, using bear-market funds in an attempt to time the market and gain from declines is a risky, dangerous game that's best avoided. In fact, these funds are most often used by sophisticated investors as a tool to temper risk by hedging a portfolio against market declines. If you have a portfolio that you fear is becoming too expensive, but you don't want to sell (perhaps for tax reasons), then putting a small part of the portfolio (no more than 5%) in a bear-market fund can limit the downside potential. If you're mainly worried about the large-cap tech stocks in your portfolio, then a Nasdaq 100 bear-market fund might be a good hedging instrument. Doing this also limits your upside potential to some extent, but that's true of any type of hedging.

However, the average individual investor almost certainly doesn't need a bear-market fund, even for hedging, and it's probably best to steer clear of them altogether. For most people, the best way to hedge risk is through old-fashioned portfolio construction--for example, adding more bonds if you're worried about your portfolio's risk level.

If you do decide to try a bear-market fund after considering all the pros and cons, it's best to avoid the ultrarisky leveraged bear funds that have been racking up huge gains lately. One of the most attractive bear-market funds is one that has not gained nearly as much as its flashier peers in the current market--Prudent Bear, which, as noted above, is the largest fund in the category. Manager David Tice is a longtime market pessimist who was warning years ago about a looming credit crisis, much like what we're experiencing now. He actively manages the fund in an effort to benefit from market declines while also avoiding big losses when the market is going up. While the fund has gained "only" 33% this year, well below most of its peers, it also posted gains each year from 2005 through 2007, when most of those peers suffered big losses. Its three-, five-, and 10-year returns are all among the best in the bear-market category. While Prudent Bear has sometimes lost money, it comes closest to the ideal of providing downside protection without too much danger of losing money in a bull market. It's worth noting that the fund is being sold to Federated, after which Tice will scale back his direct involvement; however, Doug Noland, who has already been responsible for much of the fund's day-to-day operations in recent years, will still be around, and we don't expect any dramatic changes.