Like the name implies, these funds aim to make money when the market tanks, but they have varying success.

By Bob Frick, March 20, 2008

Bear market funds dominate the list of top performing mutual funds so far this year. Much like synchronized swimming, these funds, which are designed to prosper in sinking markets, are the subject of ridicule most of the time. Once the Olympics come around, though, even synchronized swimming gets its day in the sun or, more precisely, the water.

Because your own investing medal count may be low now, the idea of investing in a bear market fund may not look as dumb as it usually does. So here’s a primer on bear market funds, and some financial and psychological reasons you may want to consider them. For the most part, these funds are extremely risky, so you have to be a sophisticated, or very lucky, investor to use them profitably.

Just like regular funds, bear funds come in two varieties: actively managed funds and index funds. Most bear market funds are designed to track a particular market index in reverse — more on those later. The actively managed funds try to make money not only when the broad stock market sinks but also make money — or at least break even — when stocks are generally rising.

The best of the actively managed funds, by far, is Prudent Bear (symbol BEARX ). Over the past five years through March 19, Prudent Bear actually eked out an annualized return of 1% over the past five years, even as Standard & Poor’s 500-stock gained 10% a year.

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Over that period, no other actively managed anti-market fund comes close to matching Prudent Bear’s numbers. For example, Grizzly Short (GRZZX ), run by the well-respected Steven Leuthold, lost 8% annualized, and various iterations of Comstock Capital Value (DRCVX ) and Comstock Strategy (CPFAX ) lost 10% to 11% annualized.

Prudent Bear employs three basic strategies. It bets against the entire market by selling short index futures and buying put options on indexes. It also sells short individual stocks (short sellers borrow a stock, sell it and hope to buy it back at a lower price). Finally, Prudent Bear invests heavily in precious-metals stocks, a traditional hedge against political instability, rising inflation and a weak dollar. The $1.2 billion fund has nearly 25% of its assets, the maximum allowable, in precious-metals stocks. The metals stocks are probably the main reason for the fund’s positive results over the past half-decade.

For more on Prudent Bear, see Bear Market Insurance .

Trying to time the market with a bear fund is a mistake, experts say. Steven Rog, portfolio manager of R.W. Rog in Bohemia, N.Y. says he owns some Prudent Bear shares as an insurance policy. Instead of selling off a big portion of portfolios he manages and having his clients take capital-gains hits, he says, he can sell half as much and still be protected from a major market downturn by owning Prudent Bear.

There’s also a psychological benefit to owning a bear fund, Rog says. When the market plunges, as it has done on many days during the current rough patch, a bear fund will mitigate your losses. Let’s call it a floor on the emotional distress that clients will feel, Rog says.

If you’re worried about the market and want some protection, some Prudent Bear in your portfolio might save you from doing something rash and imprudent — such as selling all of your stock holdings and vowing to never invest in the market again.

Unlike Prudent Bear, most bear market funds simply track a particular market benchmark in reverse. Consider Direxion Nasdaq-100 Bear 2.5 X. This fund is designed to produce 2.5 times the inverse of the Nasdaq 100’s daily return (the Nasdaq 100 tracks the 100 largest non-financial stocks on Nasdaq).

This incredibly volatile fund is the top performer so far in 2008, having gained a remarkable 53% through March 19. (How volatile is it? On March 18, the day on which the Dow Jones industrial soared 420 points, or the Direxion fund lost 10.9%; on March 19, when the Dow plunged 293 points, or 2.4%, the Direxion fund jumped 6.0%.)

Here’s a little more detail on how bear funds can profit in a down market by selling short index futures. Assume you wanted to short the Nasdaq 100, which is an index representing the 100 biggest, non-financial stocks on the Nasdaq stock exchange. You’d borrow a Nasdaq 100 index future, sell it, hope it goes down in price, then buy it back and make a profit on the difference. The Direxion Nasdaq-100 Bear 2.5 X uses leverage — it borrows — to achieve 2.5 times the inverse of the Nasdaq 100’s daily return.

Shorting is a complicated process and these types of funds have varying success in tracking the inverse of an index. For example, while the Nasdaq 100 was down 18% year to date through March 19, Direxion Nasdaq-100 Bear 2.5 X was up nearly three times that amount. Sometimes these variances give investors a better return than they’d expect, sometimes the returns are worse.

Bear market funds have proliferated in recent years and now cover most indexes. If there’s a market, you can probably short it. Bear funds cover all broad market indexes, such as the S&P 500, which tracks big-company stocks; the Russell 2000 index of small-company stocks (there are separate bear funds for the Russell 2000 value-stock and Russell 2000 growth-stock indexes); and all different stripes of foreign stocks, from emerging markets to Europe to Japan.

And in recent years, bear funds have parsed the market into finer segments. You can now short oil and gas, precious metals and real estate, for example. The biggest investment companies that run bear funds, Rydex and ProFunds, also sell exchange traded funds that short indexes.

While money is rushing into them now, the total assets in all bear market funds are still only around $17 billion. If all those assets were in a single bear fund, that fund would rank around 90th on the list of all funds by size.

ProFunds claims more than 80% of the bear fund market through its 120 ProShares ETFs and ProFunds mutual funds. ProFunds chief executive Michael Sapir says the ETFs are used by hedge funds and large endowments, down to financial advisers, and by some individual investors. Sapir is careful to say that neither the bear ETFs nor the regular bear funds are actively marketed to mom and pop investors.

That’s a good thing, because if the market rises, you’ll have your head handed to you with a bear index fund, particularly one that magnifies the market’s results. If you were betting on the bear hitting the Nasdaq 100 last year and invested in Direxion Nasdaq-100 Bear 2.5X, you bet wrong. The index gained 19% last year, and the fund plummeted 36%.