Two market crashes in a decade haven’t helped bear-market mutual funds avoid the distinction of worst-performing strategy. The only exception: Bill Gross.
Gross, best-known for overseeing the world’s biggest bond mutual fund at Pacific Investment Management Co., also runs the top-ranked fund that bets on a decline in stocks. The $1.6 billion Pimco Stocksplus TR Short Strategy Fund (PSTIX) has advanced 3 percent annually in the past five years, the only bear-market mutual fund to beat U.S. stocks over that period, according to Morningstar Inc. (MORN) Bear funds trailed equities over five and 10 years, and were the worst performers over both periods.
“Few people are smart enough to tell where the market is going,” Geoff Bobroff, an East Greenwich, Rhode Island-based consultant to money managers, said in an interview. “Bill Gross and his team have developed the right tool kit here.”
Bear funds have failed to profit from two crashes in a decade, the second of which, from 2007 to 2009, erased $11 trillion in market value and left the Standard & Poor’s 500 Index below where it stood 11 years ago. After surging a record 30 percent in 2008, the funds slumped 34 percent in 2009 and 24 percent the following year as the stock market rebounded, according to Morningstar, which is based in Chicago.
U.S. mutual funds that short, or wager on a decline in stock markets, have on average tumbled at an annual rate of 10 percent over the 10 years through March, the most of 90 strategies tracked by Morningstar. They’ve fallen 13 percent over the past five years. The group includes 42 funds, with active as well as passive strategies, some of which attempt to amplify market gains or losses.
“Bear funds have had a really poor track record,” Nadia Papagiannis, an analyst at Morningstar, said in an interview. “One period of good performance isn’t good enough to make up for several years of poor performance.”
The funds have been a niche strategy since the first were started in the mid-1980s. They have about $4.8 billion in assets, accounting for less than 0.1 percent of the $8.4 trillion in stock and bond assets, Morningstar data show. Funds that invest in large-company stocks, the most popular, have about $2.4 trillion in assets.
Bear funds have attracted money after the recent market crashes, with investors pouring $4.7 billion into the strategy in 2009 and 2010. Assets in bear mutual funds peaked at $5.5 billion as of Dec. 31.
The funds can bet against the stock market by short-selling individual stocks or by using derivatives to short indexes such as the S&P 500. Shorting involves selling borrowed securities with the expectation that their value will fall and they can be bought back cheaper at a later time.
Gross’s fund, started in 2003 to provide “inverse exposure” to the market, uses derivatives to bet against the stock market, and may use borrowed money and fixed-income securities to lift returns, according to information posted on the website of Newport Beach, California-based Pimco.
The fund allows investors to potentially profit in two ways. If the stock market is declining, investors gain from the short positions. If the stock market is rising, investors can offset losses from the short positions through the fixed-income portfolio. The Pimco fund returned 49 percent in 2008 when the S&P 500 fell 38.5 percent. The fund declined 14 percent in 2009 and 8.5 percent in 2010.
‘Difficult on Bears’
“In effect, it’s two funds in one,” said Rick Lake, co- chairman of Greenwich, Connecticut-based Lake Partners Inc., which advises institutions on $3.5 billion in assets. “The outperformance is due to the recent strong performance of bond funds in general and Pimco bond funds in particular.”
Gross was not available for comment, said Mark Porterfield, a spokesman for Pimco.
Unprecedented efforts by the Federal Reserve to stimulate the economy have helped the Standard & Poor’s 500 Index double from its March 2009 low. That hurt funds including those founded by David Tice and Charles Minter, who are known for their persistently gloomy views on the market.
“Prices do diverge from fundamentals if you have so much government intervention,” Douglas Noland, who has worked with Tice for more than a decade, said in an telephone interview. “It’s very difficult on us bears. It’s frustrating.”
Noland and colleague Ryan Bend run the $1.3 billion Federated Prudent Bear Fund, which was founded by Tice and profited from the managers’ conviction in late 2007 that stocks would fall 50 percent. The fund, owned by Pittsburgh-based Federated Investors Inc. (FII), rose 27 percent the following year. It has fallen 44 percent since March 9, 2009.
The top-performing actively managed bear mutual fund during 2008 was Steven Leuthold’s $90 million Grizzly Short Fund (GRZZX), which returned 74 percent. Even with that gain, the fund has declined at an annual rate of 9 percent over the past five years.
Funds that magnify the inverse return of a specific index have been hurt particularly bad. The Direxion Monthly Emerging Markets Bear 2x Fund, which aims to provide investors with twice the inverse return of an emerging markets index, is down 51 percent over five years, the worst performer in the category.
“Leveraged funds can really amplify losses,” Morningstar’s Papagiannis said.
Paying a Premium
Funds that employ techniques such as shorting are also more expensive than traditional long-only funds, said Todd Rosenbluth, a senior director at New York-based Standard & Poor’s. The average expense ratio of funds that have the ability to short is 2 percent, compared with 1.3 percent for large-cap value funds, he said.
“Investors are paying 70 basis points more for these alternative strategies, which will hurt returns even more,” he said.
The Federated Prudent Bear Fund and the $97 million Comstock Capital Value Fund (DRCVX), the oldest bear-market mutual fund, use a combination of options, short sales and fixed-income securities that reflect their conviction that the U.S. stock market will decline.
Comstock Partners, which is owned by Mario Gabelli’s Rye, New York-based mutual-fund company Gamco Investors Inc. (GBL), in 1985 opened a mutual fund that allowed managers to bet on rising as well as falling markets. Minter said he started out bullish and turned pessimistic just before the stock market crash of 1987. Betting on a decline in equities helped the Comstock fund return 34 percent in 1987, when the S&P 500 rose 2 percent, according to data compiled by Bloomberg.
‘We Got Slaughtered’
The Comstock fund, managed by Minter and Martin Weiner, suffered when the managers doubted the stock market rally from 1995 to 2000. Their skepticism only paid off after the market crashed in 2001 and 2002, helping the fund advance 65 percent during those two years. In the four-year market recovery that started in 2003, the fund lost 51 percent.
Moves by then-Federal Reserve Chairman Alan Greenspan “created a cyclical bull market between 2003 and 2007,” Minter said in a telephone interview from Philadelphia. “We got slaughtered throughout that period,” Minter said.
In a March report outlining Comstock’s macroeconomic forecast, Minter and Weiner said U.S. stocks are in a “secular bear market.” The rising levels of U.S. debt, continuing weakness of the U.S. housing market, and high valuations of U.S. stocks will push the market down over the next several years, the managers said.
‘Two Ways to Lose’
Pimco’s Gross and Chief Executive Officer Mohamed El-Erian have coined the term “new normal” to describe diminishing market returns against the backdrop of higher government intervention, persistent unemployment and the decreasing role of the U.S. in the world economy.
Despite the Pimco bear fund’s performance relative to peers, Lake Partners’ Lake said investors need to be “judicious” about how much they put into such strategies. The Pimco fund may be vulnerable to losses if the stock market continues to go up and an increase in interest rates pushes bond returns down.
“If that happens, investors potentially have two ways to lose money,” Lake said. “There is no all-weather strategy.”
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