Betting on a Bear Market

Bear market funds dominate the list of top-performing mutual funds so far this year. For the most part, however, these funds are extremely risky. So you have to be a sophisticated, or very lucky, investor to use them profitably.

Just like regular funds, bear funds come in two varieties: actively managed funds and index funds. Most bear market funds are designed to track a particular market index in reverse. The actively managed funds try to make money not only when the broad stock market sinks but also make money -- or at least break even -- when stocks are generally rising.

The best of the actively managed funds, by far, is Prudent Bear (symbol BEARX). Over the past five years through March 19, Prudent Bear actually eked out an annualized return of 1 percent, even as Standard & Poor's 500-stock index gained 10 percent a year.

Trying to time the market with a bear fund is a mistake, experts say. Steven Rogé, portfolio manager of R.W. Rogé in Bohemia, N.Y., said he owns some Prudent Bear shares as an "insurance policy." Instead of selling off a big portion of portfolios he manages and having his clients take capital-gains hits, he said, he can sell half as much and still be protected from a major market downturn by owning Prudent Bear.

There's also a psychological benefit to owning a bear fund, Rogé says. When the market plunges, as it has done on many days during the current rough patch, a bear fund will mitigate your losses.

Unlike Prudent Bear, most bear market funds simply track a particular market benchmark in reverse. Consider Direxion Nasdaq-100 Bear 2.5 X. This fund is designed to produce 2.5 times the inverse of the Nasdaq 100's daily return (the Nasdaq 100 tracks the 100 largest nonfinancial stocks on Nasdaq).

This incredibly volatile fund is the top performer so far in 2008, having gained a remarkable 53 percent through March 19. (How volatile is it? On March 18, the day on which the Dow Jones industrial average soared 420 points, the Direxion fund lost 10.9 percent; on March 19, when the Dow plunged 293 points, or 2.4 percent, the Direxion fund jumped 6 percent.)

Bear market funds have proliferated in recent years and now cover most indexes. If there's a market, you can probably short it. Bear funds cover all broad market indexes, such as the S&P 500, which tracks big-company stocks; the Russell 2000 index of small-company stocks (there are separate bear funds for the Russell 2000 value-stock and Russell 2000 growth-stock indexes); and all different stripes of foreign stocks, from emerging markets to Europe to Japan.

And in recent years, bear funds have parsed the market into finer segments. You can now short oil and gas, precious metals and real estate, for example. The biggest investment companies that run bear funds, Rydex and ProFunds, also sell exchange-traded funds that short indexes.