Publish date:

How to Capitalize on a Falling Market

These funds and ETFs bet on bearish turns.

Remember, the bears ate Goldilocks at the end of the story.

Much like Goldie, investors have grown complacent about an economy that is not too hot and not too cold. But as the stock rally wanes -- especially after the

Dow Jones Industrial Average's

more than 800-point drop over the past two weeks -- it's time to consider that you might wake up to a room full of bears.

Many strategies purport to make money in a down market. Bonds are the classic way to seek safety and get a guaranteed rate of return. Gold, too, generally holds -- if not increases -- in value when equities fall. Other commodities also rarely move in line with equities. Even currencies can be used as a hedge. But if you believe stocks are due to tumble, the pure play is to short-sell equities or bet against their indexes.

Three companies have made their reputations by offering mutual funds and exchange-traded funds that go up when the market goes down.

The Ursa Major is the

(BEARX) - Get Federated Prudent Bear A Report

Prudent Bear Fund , the oldest and best-known of the group. Founded and run by David Tice, the fund has been shorting stocks for the past 12 years. Short-selling is when a bearish investor borrows shares and sells them, hoping to buy them back later at a lower price and pocket the difference. If the stock's price rises in the meantime, however, the investor is on the hook to buy the shares at a higher price and return the borrowed shares, taking a loss.

Short stocks make up 75% of the Prudent Bear portfolio, with options to sell the indices making up 3%. But not everything is a short play. The fund is long precious metals stocks, which comprise about 17% of the portfolio. In addition, because you don't need to spend money to short stocks, the assets allocated to shorting are invested in Treasury bonds and earn interest. There is zero leverage in the fund.

Because most of the other bear funds short the broad stock indices, Tice's stock-picking has made this the best-performing bear fund over the three, five and 10-year periods. When a fund bets against the index and the index rises, the fund loses money.

But, because of the stock selection and being long precious metals, the Prudent Bear Fund actually rose 9.1% in 2006, even as the

S&P 500

jumped 13.6%. Year to date through Thursday, the Prudent Bear is up 6.15%, compared with the S&P 500's 3.8% gain. The fund has no commission, an expense ratio of 1.77% and $784 million in assets under management. The minimum investment is $2,000.

As of the fund's March 31 report, it was short

General Motors

(GM) - Get General Motors Company (GM) Report

,

Citigroup

(C) - Get Citigroup Inc. Report

,

Goldman Sachs

(GS) - Get Goldman Sachs Group, Inc. (GS) Report

and

TheStreet Recommends

Motorola

(MOT)

.

Tice thinks that the U.S. is entering a bear market that could last for years. "Risk has been mispriced over the last three years," he says. "Now that risk is being repriced higher."

Rydex Investments offers 11 mutual funds that are designed to make money in a bear market. Eight funds are straight bets against major indexes. Four seek the exact opposite return of some key indexes and four use leverage to double the inverse return.

Each inverse index fund holds a portfolio of index futures, options and swaps to create an index that behaves inversely to the index it tracks. David Reilly, Rydex's director of portfolio strategy, says that instead of shorting the component stocks, it's better to use derivatives that don't have the trading costs associated with shorting a basket of stocks. For addressing risk, "the inverse funds are clearly the most effective option," Reilly says. "They are very straightforward."

These funds are intended to be sold through investment advisers and carry a front-end load. The expense ratios range from 1.41% to 1.69%.

Rydex also offers three alternative funds that employ strategies similar to hedge funds that attempt to generate returns no matter what the broad market is doing. They don't invest solely in equities, but tend to hold alternative assets with a low or no correlation to stocks.

The

(RYMSX) - Get Guggenheim Multi-Hedge Strats P Report

Absolute Return Strategies fund seeks to replicate the characteristics and return of the hedge fund index of funds. Morningstar classifies it as a "Long-Short" fund. And like the Prudent Bear fund it can post a positive gain even when the broader market is up. Last year, the Absolute Return fund earned 6.6% and year to date it is up 3%. It has an expense ratio of 1.83%.

The

(RYSTX)

Rydex Hedged Equity fund seeks to replicate the return of the Dow Jones Hedge Fund Equity Long/Short Index which shorts stocks, as well as ETF futures and options. Last year it returned a gain of 8.3% and is up 3.5% so far this year. It has an expense ratio of 2.07%.

Finally, the

(RYMFX) - Get Guggenheim Mgd Futures Strat P Report

Rydex Managed Futures Strategy Fund seeks to mirror the performance of the Standard & Poor's Diversified Trends Indicator. This index is comprised of 14 sectors, with 50% allocated to financial futures and 50% to commodity futures. Launched in March, the fund is flat for the year and charges a fee of 1.65%.

ProFunds also offers 11 mutual funds that short and double, or ultra, short the market indexes. These funds short index futures contracts and hold swap agreements, which are contracts between two parties to exchange a revenue stream.

(BRPIX) - Get ProFunds Bear Fund Inv Report

The Bear Fund and

(URPIX) - Get ProFunds UltraBear Fund Inv Report

UltraBear track the inverse of the S&P 500. The funds have expense ratios ranging from 1.38% to 1.95%.

A cheaper way to buy these inverse funds is to go to ProFunds ETF unit, ProShares. Twenty nine of ProShares 52 ETFs short the market. They are cheaper and more flexible than a mutual fund because they trade throughout the day, unlike funds, which are priced just once a day. These ETFs charge an expense ratio of 0.95%.

But you don't have to be a bear to buy a bear fund. As market volatility increases, even a bullish investor might want to take a small position in a bear fund as a hedge against uncertainty.