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Fund Investors: Do Not Feed the Bears

Catherine Valenti

After years of sitting out the stellar gains of the bull market, bear market mutual funds are finally getting their day, trouncing the pack in the first quarter of this ugly year. But many market watchers say these funds aren't be the best choice for the long-term investor.

It's no surprise that bear market funds are dominating the list of top performing mutual funds for the first quarter of 2001. As of March 29, seven of the top 10 performing funds in the quarter were bear funds, according to Lipper.

These funds, which move in the opposite direction of the general market by using techniques such as shorting stocks or buying futures contracts against major market indices, have been posting stellar gains as funds that are long the market wallow in the doldrums.

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"I think that over the long haul, a bear market fund is just going to be a drag on returns," says Morningstar's director of fund analysis Russ Kinnel. "For a rainy day, cash or short-term bonds are at least going to earn positive returns over time."

Sure, these funds are doing well now that the broader markets are tanking, but whether the bearishness will continue is the subject of great debate. There are those who say that we are due for a good, long bear run to counter the excesses of the speculative tech bubble of the past few years, while others don't expect the current downward trend to plague the market for much longer.

Even if you have a dismal view of the market, it is important to consider a few factors before buying a bear market fund. Bear market funds move against the momentum of the stock market, which has given investors a historical long-term average annual return of 11.3% from 1926 to 1999, according to mutual fund group Vanguard. In the past decade, investors have enjoyed an even higher average annual return of 18.2% from the stock market, reports Vanguard. In contrast, bear market funds, many of which have not been around for very long, have been wallflowers during the late 1990's stock market party.

Source: InvesTech Research

Morningstar's Kinnel says that with the S&P 500 down 13.1% and the Nasdaq 100 down 26.3% so far this year, it might even be a good time to take profits if you're holding a bear market fund.

"If you're shorting [the market] today, you're shorting it at cheaper valuations than they were a year ago, so why weren't you shorting it then?" says Kinnel.

The flip side is that many believe the market hasn't yet seen the worst of it. James B. Stack, founder and president of InvesTech Research in Whitefish, Mont., says that the past three market declines of 1981, 1987 and 1990 were below average both in the length of time the market was bearish and in the time it took to recover. This leads some to believe that the market might be poised for a prolonged period of dramatic underperformance.

"Secular bear markets follow secular bull markets," says David Tice, portfolio manager of the (BEARX Quote)Prudent Bear fund, which is up 16.2% so far this year. "The more alcohol you drink the more hungover you're going to be the next morning, and the excesses from this mania are extreme."

Other fund managers say that bear market funds should not be used not as a call on the market, but rather as downside protection for your portfolio. Michael Sapir, chairman and chief executive of ProFunds, which offers the (URPIX Quote)ProFunds UltraBear and the (BRPIX Quote)ProFunds Bear along with a host of bullish funds, says his firm is simply offering investors the tools to be able to take whatever position they want on the markets.

Sapir says instead of selling out of their stock positions, investors can buy bear market funds to use as hedges against their long-term portfolios. On top of ProFunds' bear market funds, which move in the opposite direction of the S&P 500, the firm also has two funds that inversely track the Nasdaq 100, the (UOPIX Quote)ProFunds Ultra OTC and the (USPIX Quote)ProFunds UltraShort OTC Inv.

"It's like insurance: When you have life insurance for a year, you don't say at the end of the year, 'Darn I shouldn't have bought life insurance,'" says Sapir. "These can be very useful short term tools to manage your portfolio."

George Tennes, senior portfolio manager of the (RYURX Quote)Rydex Ursa fund says that investors have shown more interest in the bearish fund during times when the market is doing well.

"These funds sell very well when the markets are zooming," says Tennes. "People are wishing to hedge the long positions that they're holding."

However, some market observers point out that there are more cost effective ways to hedge. For example, investors could short the (QQQ Quote)Nasdaq 100 Index Tracking Stock or the (SPY Quote)Standard & Poor's Depositary Receipts, which have expense ratios of 0.18% and 0.12%, respectively, compared with a 1.41% ratio for the ProFunds Ultra Bear or a 2.36% ratio for the Prudent Bear fund.

"You would have been much better off just shorting the QQQ rather than going into one of these bear funds," says Dr. Jeremy Siegel, professor of finance at the Wharton School of Business. Also, investors can opt to insulate themselves from market turmoil by having diversified portfolios that include growth and value offerings, as well as some bond and cash holdings.

Indeed, even though bear funds have been impressive of late, fund managers say investors aren't exactly running for the exits to buy these funds. Sapir, Tice and Tennes all report modest inflows into their bear funds in recent months, signaling that there are many mutual fund investors who aren't quite ready to throw in the towel in large numbers.