Dear Dagen: Do Not Feed the Bear Funds

What do you think of investing in bear funds? I am interested in several of these funds, including (RYVNX Quote)Rydex Venture 100, (DCVBX Quote)Comstock Capital Value and (BEARX Quote)Prudent Bear. I am just not sure if these funds are likely to behave well if the market ever recovers. Is it worth having these kinds of funds in your portfolio to balance the growth or index funds?

--Larry Schlanger

Bear funds sure do look like the perfect investment.

Like the name says, these funds are designed to do well in a bear market. And, boy, are we in one now. The S&P 500 is down almost 24% this year alone. The Nasdaq looks even worse.

However, a bear fund is not a panacea for everything that ails your portfolio. In fact, in an attempt to "diversify," you often leave yourself even more exposed to market-timing risks and, to boot, pay more in expenses.

Just like so many people rushed into tech funds after their triple-digit gains in 1999, investors might be tempted to pounce on a bear fund, thinking that stocks will keep going down. But market timing is difficult, if not impossible, to do for most people. Plus, there are cheaper and easier ways to give your portfolio some balance.

But first, you need to know the basic differences between the bear funds out there. You'll find funds run by companies like Rydex and ProFunds that are designed to track indexes in reverse. These funds are bets against indexes like the S&P or indexes that track sectors like the Internet and retailing. The (RYURX Quote)Rydex Ursa, as one example, is supposed to gain the same amount that the S&P 500 loses each day and vice versa.

But some of these funds take this downside bet a step further by using leverage. The Rydex Venture 100 fund tries to return 200% of the inverse performance of the Nasdaq 100 index. On Wednesday, for instance, the fund was down 3.7%, while the Nasdaq 100 was up 1.3%. As you might imagine, these funds are extremely volatile.

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Then there are bear funds that run by managers who are actively shorting individual names. These managers try to find stocks that are going to fall rather than rise and then short them. In a short sale, an investor borrows a stock and sells it into the market with the hope that it will fall and can be bought back for a cheaper price at a later date.

The best known of these actively managed bear funds is probably David Tice's Prudent Bear fund. Tice has more short positions in his fund than long positions, and the fund is supposed to benefit when the stock market falls. To find stocks to short, he examines a range of factors, including investor sentiment and valuation.

Over the past 12 months, this fund is up 80.3%, beating the S&P 500 by 106 percentage points. But look back a few years and you'll see what can happen to a fund like this when stocks go up. It lost money in each year from 1996 through 1999, posting double-digit losses in three years.

Maybe you're thinking: I'll just put some money in one of these bear funds until the market turns and then get out. But there's one basic problem with betting on a bear fund: If you're trying to time broad moves in the market, you might lose your shirt -- and your shoes and your trousers.

It's almost impossible to predict when the market has bottomed. Maybe the market started its turnaround in July. Maybe it didn't.

"I think short funds are dangerous territory to get into," says Morningstar's Russ Kinnel. "Often you see money going in and out at the wrong time."

And as far as the long haul goes, stocks tend to go up, not down. If you want to make money over the next few decades, you want to be long, not short.

Plus, there are additional costs associated with shorting stocks that don't come with buying and holding. These funds can wrack up huge trading costs, which come right out of a fund's returns. And they can be expensive to own. The Prudent Bear fund carries an annual expense ratio of 1.86%, compared to about 1.5% for the average stock fund.

Bear funds often are labeled as a vehicle for "sophisticated investors" (and who doesn't fashion themselves as that?), but to protect your portfolio, you don't necessarily need a fund inversely correlated to stocks. It's no less sophisticated to use bonds and cash.

Bonds have a low correlation to stocks and will reduce the swings in your portfolio. Looking at the returns on different portfolios from 1970 through the end of last year, a portfolio with 95% stocks and 5% bonds lost 24.1% in its worst year, according to data from Charles Schwab. A portfolio with 30% bonds and 10% cash only lost 13.1% in its worst year. That's a big difference.

A simple way to balance your portfolio is just to ease up on your stock allocation. Anyway, you might have already missed the best time to own a bear fund. If you pile your money into one now, you could wind up missing the next rally.

And just think how insane a bear fund might make you when the market snaps back and Newsweek slaps a giant bull of its cover.