Be Careful: Bear Funds Can Bite

Now that we've been reminded that the market goes down as well as up, is it a good time to look at funds that sell short?

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QUESTION: Given that this is now a two-way market -- at least -- and possibly a bear, can you tell me about funds that specialize in short selling?

ANSWER:

Nonetheless, experts urge investors to approach bear funds with care. Devoting a portion of your holdings to one can help hedge an otherwise growth-heavy portfolio, they say, but a little goes a long way. Bear funds can inflict a nasty bite when the market heads up, and during a volatile market, owning one can give you a major case of nail-biting.

Basically, there are two kinds of bear funds: actively managed portfolios that short particular stocks, and inverse-index funds that short entire indexes. (A third group of funds, including the Needham Growth fund (NEEGX), permit managers to short a portion of their portfolio as part of a broader strategy.)

One actively managed short-selling fund, the Prudent Bear fund (BEARX), returned 30.5% in 2000. But for several years before that it lost money, dropping 23.4% in 1999, 34.1% in 1998 -- you get the picture. Another actively managed portfolio, the BearGuard fund (sorry, no snapshot available), which launched in November 1999 and has just $1.5 million in assets, gained 26.1% in 2000.

Rydex Ursa fund

RYURX

But say you figure the markets are going to stay yucky. Are these funds a good bet? Watch out, says independent investment adviser Jim Bernstein of Princeton, N.J.-based Windsor Financial Advisers. Even in a declining market, he explains, there are sudden rallies -- as when the Fed unexpectedly cut interest rates on Jan. 3. That day, the Rydex Arktos fund (RYAIX) did what it's supposed to do -- produce the inverse return of the Nasdaq 100 -- and fell roughly 18%. Meanwhile, the Rydex Venture fund (sorry, no snapshot available), which doubles the opposite of the Nasdaq, plunged about twice that. Bear funds, Bernstein says, are "tough to explain to customers when the market goes up 20% and you lose 20%." In mid-1999, he began scaling back his use of such funds and relying on money-market funds instead. "They can understand if the market goes up 20% and you have it in cash because you're trying to protect them."

Morningstar analyst Alan Papier says that the most important use of bear funds "is to hedge an area of the market where you might be overexposed." A short-selling fund could help you avoid triggering transaction costs or potential capital-gains taxes by selling a stock or fund you think is headed for a fall.

Investors can also find downside protection elsewhere. Certified financial planner Scott Kahan of Financial Asset Management in New York City calls bonds or bond funds a safer choice. "If the market turns, (a bear fund) can all of a sudden be left behind," he says. But a slim allocation to a bear fund -- perhaps 5% -- could serve an investor well.

BearGuard manager Paul McEntire views his entire portfolio as a long-term investment and himself as a kind of value investor: Rather than acquiring the most undervalued stocks, he says, he shorts the most overvalued ones. But Michael Sapir, chairman and chief executive of ProFunds, which fields three short-selling funds, insists they're strictly for short-term use. Or, as he puts it: "Sometimes we say the bear funds are funds you might want to date but not marry."

The bottom line: Tiptoe cautiously into bear country.