One strategy of late for pessimistic investors has been buying so-called short, or bear, funds, which are designed to go in the opposite direction of a particular index or an actively managed fund. In practice, when the market slips, bear funds should make money.

Investment dollars have been pouring into this asset class over the past few years. Since 2005, holdings in bear funds have jumped from $6 billion to $16 billion, according to fund data provider Lipper.

Investing in short funds isn't as complex as playing in the manic derivative market, either. Those who bet against the market in the first three months of 2008 earned about 7.5%, while market followers lost nearly 10%, according to industry data firm Hedge Fund Research. Intrigued? Here’s what you need to know.

Bear Necessities
Investors can bet against either a market index like the S&P 500, or a managed fund of shorted stocks. It depends on where their pessimism lies. ProFunds, the biggest provider of bear funds, specializes in short exchange-traded funds and has some $17 billion under management. For the more aggressive folks who are especially convinced the market will tank, "ultra" short funds offer double the inverse, such as the Rydex Inverse 2X S&P 500 ETF. So if, say, the S&P 500 falls by 2%, the short fund should rise by 4%. Rydex Investments also offers a large family of various short funds based on the Dow Jones Industrial Average and the Russell 2000 Index, among other market measures. Some, like ProFunds' offerings, are also designed to do 200 percent of the inverse of the index.

Of the short funds that actively hedge individual stocks, the Leuthold Grizzly Short Fund (Stock Quote: GRZZX) is one of the category leaders. In the second quarter of this year the fund gained 8%, versus a nearly 3% loss in the S&P 500. The fund bets against financials, housing and tech names. The Prudent Bear Fund (Stock Quote: BEARX) also shorts individual stocks, in addition to possibly implementing options and futures contracts.  

Cutoff Shorts
Limit your exposure to short funds to no more than 10%, experts say. While they offer a hedge against the market, critics say bear funds can be considerably dicey because investors need to be aggressive and time the market to make money. "You really have to make two decisions: When do I go short in the market, and when do I take my short positions off?" says Adam Bold, founder and CIO of the Mutual Fund Store. "The reality is that most people don't realize that by the time the market's going down, it is likely closer to a bottom."

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