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Investors Embrace Bear Market Funds

Lately, some of the most popular fund managers in the stock market—judging by where investors put their dollars—are those who bet against it.

So-called bear market mutual funds and exchange-traded funds have benefited from an inflow of dollars this summer, despite warnings by many investment advisers that the funds can be wrong for individual investors.

The "bear market" category includes a variety of approaches, but all are designed to profit when stocks fall. Many also use leverage, meaning they borrow in a way that can magnify both gains and losses.

According to TrimTabs Investment Research, assets at bear market exchange-traded funds, or ETFs, have risen 8.3 percent, or $1.3 billion, in the past three months. During that time, assets of bear market mutual funds, though much smaller than comparable ETFs, have gone up $33 million, or 2.34 percent, a larger percentage increase than any other domestic stock category.

Souring on Stocks

Bear market funds have grown alongside bond funds, which have pulled in $7.8 billion in the past three months. Meanwhile, investors withdrew a total of $13.1 billion from U.S. stock ETFs and mutual funds in the three months from May 21 to Aug. 24.

The growth has come despite concerns of regulators and investing experts. In August 2009, the U.S. Securities & Exchange Commission posted a warning on its website detailing the "extra risk for buy-and-hold investors" in leveraged and inverse ETFs, many of which fall in the bear market category.

But the funds have maintained their allure in a dicey market. "When investor pessimism increases, [our fund] gets flows," says Ryan Bend, portfolio manager of the Federated Prudent Bear Fund (BEARX), the largest bear market mutual fund. In the past 10 years, the Prudent Bear fund is up 9.1 percent, while the total return of the broad Standard & Poor's 500 index has been flat, according to Morningstar. So far this year (through Aug. 27), the Prudent Bear is essentially flat, down 0.7 percent, while the S&P 500 has lost 4.5 percent.

What's Behind the Surge

Investor interest intensified because of the European debt crisis, the May 6 "flash crash," and the general slide in stock prices, Bend says. Since Apr. 23, the S&P 500 is down 12.5 percent.

It's no surprise that investor behavior would follow such trends, says Michael Iachini, director of investment manager research at Charles Schwab Investment Advisory. "Investors, for better or worse, tend to chase performance," he says.

The problem is that individual investors are exiting stock funds only after they've fallen—thereby locking in losses and missing out on any potential recovery, Iachini points out.

Most bear market ETFs use derivatives to provide investors a daily return that is the inverse of a stock index's return. It's a growing category, says Morningstar fund analyst David Kathman. Amid the stock market slump of the past two years, bear market ETFs have proliferated, he says; "that's where a lot of the money has been going."

Since the beginning of 2009, according to Morningstar, 37 bear market ETFs have made their debuts, and the remaining 67 ETFs in the category were all started since June 2006.

The Trouble With Leverage

Using leverage, many ETFs also magnify returns two or three times. Thus the Direxion Daily Large Cap Bear 3X fund (BGZ) provides returns three times the inverse of the large-cap Russell 1000 index. If the Russell 1000 falls 1 percent, Direxion investors get a 3 percent positive return.

Another serious concern about many bear market funds is they are better suited for short-term traders rather than long-term investors. Inverse ETFs don't reliably track their indexes over the long term, Direxion and other ETF operators admit. ETF operators must rebalance their portfolios each night, a process that can create a large "tracking error" over several days and hurt long-term returns.

The Russell 1000 index is down 4 percent in the past three months, so in theory the Direxion Daily Large Cap Bear 3X fund should be up 12 percent. Instead, the ETF is up 2.5 percent. (So far this year, the fund has lost 3.8 percent vs. the Russell 1000's decline of 5.6 percent.)

"We cater to short-term investors," says Paul Brigandi, senior portfolio manager at Direxion. The funds are for "sophisticated investors who have time to monitor and manage the portfolio on a daily basis."

Kathman also warns that leverage can magnifies losses in a way that can be "pretty dangerous" for most investors. It's "not something most people should be fooling around with," he says.

The Appeal of Active Management

Funds that are actively managed don't have the same problems with tracking error and can be more suitable for long-term investors. The largest and most prominent is Federated Prudent Bear, which Kathman calls "the best option" in the category for individual investors, because of its managers' experience and track record.

Prudent Bear's Bend says he and other fund managers do fundamental research to pick the stocks they "short." Shorting is the process of profiting from a falling stock price by borrowing shares, selling them, and then, if one is lucky, buying them back at a lower price. The fund is usually 70 percent to 100 percent short stocks, athough it often owns gold and other precious metals stocks that do well "in times of economic turmoil," Bend says.

The move toward bear market funds is part of a broader trend toward so-called alternative funds, which employ strategies designed to keep or gain value when stock or bond prices fall. Especially since the steep stock declines of 2008 and early 2009, "more advisers and investors are looking to alternative strategies and trying to incorporate them into the overall portfolio," Bend says.

The alternative category can help reduce volatility in a portfolio, but it should never represent more than about 5 percent of an individual's holdings, Kathman says.

Consider Other Asset Classes

Steve Stahler, president of the Stahler Group, a boutique wealth management firm, urges investors not to think too narrowly when seeking alternatives to U.S. stocks and bonds. Bear market funds are "really trading vehicles," he says. "There are other asset classes out there," including real estate and foreign investments, he says.

The popularity of the alternative category is causing new funds to appear—and many lack experienced management or a "verified track record," warns Aaron Reynolds, a senior portfolio analyst at Robert W. Baird. Among alternative funds, "there is a lot of opportunity, but there are a lot more gimmicks out there."

Milo Benningfield, of Benningfield Financial Advisors in San Francisco, says alternative investments can make sense in "small doses." But he is staying away from bear market funds.

If you want to reduce your exposure to the stock market, the best way is simply to sell stocks and buy cash or bonds, he says. And, unlike other investments, bear market funds pay no interest or dividends—in fact, investors must pay the dividends of the stocks they're shorting.

"Bear market funds seem to promise something magic. They seem to promise protection during a down market, a way of making money without taking risk," Benningfield says. "They're making a false promise that they can't deliver on."

Steverman is a reporter for Bloomberg News in New York.

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