As recession looms, investors could do worse than to hedge their positions using bear-market mutual funds, which bet against upturns in the market
With the U.S. economy facing the likelihood of a recession, is it too late to jump on the bear-market bandwagon? David Tice, manager of the Prudent Bear Fund (BEARX), doesn't think so. "Unfortunately, long bull markets are typically followed by long bear markets—and we just had one hell of a bull market," Tice says. "This is going to require a 10-year secular bear market."
Admittedly, Tice thinks that is an overly gloomy assessment. "I hope I'm wrong," he says. But even with the recent market rally, bears like Tice are certainly looking smarter than average these days. Mutual funds that try to capitalize on distressed financial markets and assets make up the only diversified domestic equity-fund category to post gains so far in 2008, rising nearly 11% through Mar. 31. The typical U.S. stock fund? Down almost 11% for the first quarter of 2008, according to Morningstar (MORN), the Chicago fund-tracker.
Bear-market funds take short positions using futures and options, typically betting against an index such as the Nasdaq 100 or the Standard & Poor's 500-stock index. There are 42 bear-market mutual funds, and more than 35 bear-oriented, exchange-traded funds (ETFs), including ProShares Short S&P 500 ETF (SH) and more esoteric offerings such as the UltraShort FTSE/Xinhua China 25 ProShares ETF (FXP). The most powerful of the bunch use leverage to juice returns as much as 2.5 times the inverse of an index. In other words, when the target index loses 1% on a given day, the fund should gain 2.5%.
Don't Chase Performance
Judging by the last bear market, many of these funds will continue to shine while much else suffers. During the 2001-2002 downturn, the typical bear fund rose 20%, while diversified stock funds fell almost 16%, Morningstar says. (Most bear funds are less than a decade old, so the only relevant comparison is the 2001-2002 bear market.) J. Michael Martin, president of Financial Advantage, an investment adviser in Columbia, Md., is using the funds to capitalize on the stock market downdraft. "We're not close to a washout yet," he says.
Even if that's true, chasing performance is never a good idea. And since the funds are volatile, investors need a long-term perspective. "The reason to buy a bear-market fund is that it adds a hedge to your portfolio," says Louis Stanasolovich, a certified financial planner and president of Legend Financial Advisors in Pittsburgh. They can be used either as a broad market hedge, or as a way to position against a downturn in a specific sector. If you own a lot of technology, for example, a bear fund that focuses on the Nasdaq will hedge your position, albeit imperfectly. Given the funds' volatility, David Kathman, a Morningstar mutual fund analyst, recommends taking no more than a 5% stake in bear funds.
One Bear That Runs With Bulls
The majority of bear funds tend to hibernate during bull markets—the typical one was down an annualized 11% during the past five years—but the $1.2 billion Prudent Bear Fund has managed to shine in healthy markets, too. It posted gains in five of the past seven years, rising 9.1% in 2006, while the S&P gained 16%. The fund accomplished that because it is actively managed and includes individual stocks Tice expects will fall—as well as rise. In fact, 99% of the fund's long positions are in precious metals stocks, such as Capstone Mining (CS.TO) and Golden Cycle Gold (GCGC). Betting on metals "is not a perfect hedge, but it's a natural hedge against [Federal Reserve Chairman Ben] Bernanke's money printing and credit creation," Tice says.
Aside from a slightly overweight position in technology, Tice is not betting against any particular sectors right now—in fact, he has cut the fund's larger-than-average short position in consumer discretionary names. (Although Tice was reluctant to talk about specific short positions, it's likely the fund trimmed its holdings in consumer discretionary stocks such as Bed Bath & Beyond (BBBY), Sears (SHLD), Starbucks (SBUX), and Whole Foods Market (WFMI)—those stocks appeared in the fund's top 20 holdings at the end of 2007.) "With $2.3 trillion in hedge funds and a lot of short positions, shorting stocks has been difficult in crowded names like the retailers," Tice says.
Other stocks on the hit list may be AutoNation (AN) and CarMax (KMX), also among the top holdings at year-end. "We think there are going to be a lot less cars sold," Tice says.
To find potential short positions, Tice is looking for companies that are depending on financing to boost growth rates. "We are looking for companies that are adding stores and expanding dramatically, that need to go to the financial market for financing. Those are great stories for us," he says.
Bear Funds Can Be Pricey
While the amount of money flowing into the Prudent Bear Fund has been flat in the past month, bear funds have lured $3.7 billion in new assets year-to-date through Mar. 26, according to AMG Data Services, an Arcata (Calif.)-based fund-tracker. Among index-linked bear funds, the ones attracting the most new money short the Russell 2000 Index, which has dropped in the wake of a seven-year bull run for small-company stocks. But David Kaiser, president of Pinnacor Financial Group, a wealth-management firm in Denver, is shifting his focus to funds that bet against bigger companies. Some of the ETFs he uses include ProShares Ultra Short Dow 30 (DXD) and ProShares UltraShort S&P 500 (SDS).
Whatever the fund, bear in mind that inverse funds can be expensive. The typical bear mutual fund has an expense ratio of 2.19%, while U.S. stock funds cost 1.4%. Bear ETFs charge 0.95% of assets; the ratio for the average U.S. major market ETF is just 0.53%. With so much market volatility, the extra cost may be just a small price to pay for nervous investors.