Bear Funds: Should You Bite Or Not?

They may serve you now, but if the bull market returns, they'll fail you

Despite its recent bounce, the Nasdaq Composite Index is still down 24% from its Mar. 10 peak. If you feel the slide is a sign that the bull market is winding down, then bear funds may be for you.

These mutual funds use tactics like selling short to make money when the stock market falls. Owning bear funds can help investors lower their portfolio risk by hedging--something many pros do routinely. The idea is to play both sides of the market, so that gains in the bear fund offset losses elsewhere in your portfolio when equities slump. "We are making professional tools available to individual investors," says Michael Sapir, chief executive officer of ProFunds Advisors, which runs three of the 11 bear funds currently on the market.

While bear funds may be sound tactical plays, they have turned out to be lousy long-term investments because the stock market has staged only brief corrections during its nine-year bull run. "Short sellers can make money in a sideways or moderately bull market, but not when the stock market goes straight up," says Harry Strunk, a Palm Beach (Fla.) consultant who tracks money managers. For example, Rydex Series Trust Ursa Fund, whose 1994 launch makes it the oldest bear fund, has declined an average 14.2% annually over the past five years. Still, day traders and others wanting to bet against short-term market moves have found bear funds useful. "You want to date a bear fund, but you don't want to marry one," quips ProFunds' Sapir.

Bear funds follow two basic strategies (table). A few, such as Prudent Bear Fund, focus on short sales of individual stocks that, managers believe, are overvalued and poised for a fall. But the majority of the funds have a simpler approach. They are structured to move in the opposite direction of a particular stock index, like the Standard & Poor's 500, the Nasdaq Composite, or the Russell 2000. Consider, for instance, ProFunds UltraShort OTC Fund, which gained 41.7% from Mar. 10 to May 31. Fund manager William Seale achieved this result by selling Nasdaq 100 index futures contracts short. The fund's goal is to move twice as much as the Nasdaq 100, but in the opposite direction. Another big winner of late is Potomac Internet/Short Fund, which has gained 35.6% since the Nasdaq market peaked. The fund invests in a mix of put options and futures contracts to try to achieve the mirror image of the Dow Jones Internet index.

Paul McEntire, manager of the BearGuard Fund, says he doesn't bet on the direction of individual indexes. Instead, he focuses on short sales of companies that are overvalued. In a short sale, an investor sells borrowed stock with the hope of buying it back later at a lower price and then pocketing the difference. That strategy is riskier than buying stocks, because losses theoretically can be unlimited.

Among things McEntire looks for are signs of executives dumping shares or of aggressive accounting practices. "I search for stocks just like Peter Lynch would, looking at price-to-sales ratios and other traditional valuation benchmarks," McEntire says. The seasoned short-seller, who for 11 years ran a hedge fund specializing in short-selling, says he created BearGuard Fund last November because sky-high dot-com and tech stocks led him to believe that a pullback was inevitable. For instance, McEntire says he shorted at $10.80; the stock has since fallen to $1.81. Another winner in his portfolio is Edgar Online, which McEntire shorted at $12.68; the stock has since fallen 68%, to $4.08. Other former momentum stocks that McEntire has shorted include Peregrine Systems, which has fallen from $40.46 to $23.19, and Red Hat, which McEntire shorted at $27.62 and which recently traded at $17.94.

Nearly 40% of BearGuard's $1.6 million in assets consists of short positions in Internet and other technology stocks, McEntire says. The fund also holds short positions in retail stocks, including Kohls, Home Depot, and telecommunications companies such as Vodafone AirTouch.

BAD TIMING. Although interest is rising in bear funds as the Nasdaq has waned, they do have some drawbacks in addition to their poor long-term returns. Harold Evensky, a Coral Gables (Fla.) financial planner, says the high expenses of some bear funds make them a costly way to diversify your portfolio. Bear funds carry an average expense ratio of 1.77%, vs. 1.55% for the average stock fund and 0.67% for the typical stock index fund, according to Morningstar. A less costly way to reduce the risk in your portfolio, he says, is to hold mutual funds with a variety of assets, including large and small stocks, value and growth stocks, international equities, and bonds. These investments tend to move in different directions over periods of several years, which helps to smooth out a portfolio's ups and downs.

Another problem with bear funds is that investors tend to get their timing wrong, says Peter DiTeresa, a senior analyst at Morningstar, who points to Prudent Bear as an example. The fund surged 68% during the summer and fall of 1998, when concerns about the Asian financial crisis caused the S&P 500 to drop 19% and the Nasdaq Composite index to lose 29%. During that period, Prudent Bear's assets jumped more than fivefold, to $289 million, as investors flocked to the fund. But the fund's performance quickly collapsed as the crisis eased and the S&P rebounded. Prudent Bear currently has $190 million in assets. "If you can time the market, bear funds make a lot of sense," Evensky says, "because you'll know exactly when you need their protection. But the problem is: Who can accurately time the market?"

To bears, that's not the point. Bear funds, they insist, are like insurance policies. Says Prudent Bear's manager David Tice: "Even if it's costly, you may want to have a bear fund around when times are good--because the good times may not last forever."

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