Investors Embrace Bear Market Funds

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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 in Bloomberg's Chicago bureau.

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