Every so often, you come across something at an antique store that makes you wonder: What on earth was that used for? Celery vases, for example. Celery used to be a novelty, so you bought special vases to display it. Other things, such as left-handed monkey wrenches, need more elaborate explanations, often provided by helpful sales people.
Which brings us to bear-market funds. They are remarkably popular, but do you need them? In most cases, no.
As their name implies, bear-market funds go south when the Standard & Poor's 500 stock index heads north, and vice-versa. Morningstar counts 28 bear-market or inverse-trading mutual funds, with $3.1 billion in assets, and another 83 bear-market or inverse ETFs with $10 billion in assets.
Given the number of bear-market funds and the amount of assets, one would assume that there is a rational reason to invest in them. But many advisers are skeptical. "I have not found a way to legitimately incorporate these beasts into clients' portfolios," said Simon Brady, founder and principal of Anglia Advisors. "I generally exclusively recommend ETFs to clients and the bear market products in ETF wrappers are poor. The average investor does not understand what comes with shorting the market and I will not invest in anything a client does not understand."
The last point is worth noting: It's bad enough to move a client to cash and miss a big upturn. It's quite another story to move a client to an investment that can transform a big upturn into a big downturn. For example, an investment in a popular bear-market fund, Rydex Inverse S&P Strategy (RYURX), would have turned a $10,000 investment into $4,582 the past five years.
Jamie Ebersole, CEO at Ebersole Financial, notes there's an additional risk for advisers who use bear funds. "There were a lot of lawsuits/arbitration claims for these funds historically, so they're not worth the risk at this point," he said.
One argument for bear funds might be to hedge away risk for a client who has a large position that he doesn't want to sell, because he doesn't want to incur taxes, said Brad Lamensdorf, CEO of research firm Lmtr.com. An executive with a large bank, for example, could hedge some of her exposure with a short financial services ETF. (He could also use put options or individual short sales, of course).
You could, theoretically, use bear funds to hedge out some risk in a stock portfolio. Is there merit in that? Some — but not a lot. Suppose you invested $10,000 in the Vanguard 500 at the start of 1997. By the end of 2016, you'd have $43,107 in your account. But it would have been a rugged ride: The S&P lost 37% in 2008 and 22% in 2002.
Now let's say you'd put $9,000 in the S&P at the same time, and $1,000 in the Rydex Inverse S&P 500 Strategy fund, which seeks to return, before fees, the inverse of the S&P 500 on a daily basis. You rebalanced to 90% long and 10% short every year. Twenty years later, you'd have $36,382 in your account, albeit with mildly reduced volatility.
Timing of course, is everything. It's worth noting that the death knell for this strategy was the current long bull market, now in its 8th year. Had you followed the strategy from 1997 through 2009, you would beaten the return from the S&P 500 alone, albeit by a small margin. Normally, bull markets aren't quite this long, nor are full-blown bear markets quite this rare.
Given that these funds are popular — and will become more so if the stock market turns down — there's a middle ground between bear-market index funds and cash. That middle ground could also become more popular if rising rates spark the next downturn, since higher rates will also hurt bond funds, the traditional bear repellent of choice.
These bear funds are active stock-pickers, but they look for overpriced stocks to sell short — which, in theory, produce a bigger win in bear markets than a short index fund.
The Grizzly Short Fund (GRZZX), for example, shorts stocks that meet its overpriced criteria, such as Westinghouse Air Brake Technologies, down 15% this year. The fund is down 9.68% for 2017, vs. 8.87% for the Rydex Inverse Strategy fund. In the grizzly-bear market of 2008, the fund soared 73.7%, but tumbled 47.17% the following year.
AdvisorShares Ranger Equity Bear ETF (HDGE) is an actively managed ETF that also bets against overpriced stocks, with shorts on Snap-On Tools, down 16.02% this year, and O'Reilly Automotive, down 28.95%. "When the market drops 10%, we hope to be up 15% to 20%," said Mr. Lamensdorf, who co-manages the fund. So far this year, the fund is down 3.89%.
The most successful bear fund, in terms of assets, is the $2.3 billion PIMCO StocksPLUS Short fund (PSTIX), which combines PIMCO's bond prowess with selective short selling. The fund jumped 48.56% in 2008, vs. a 37% loss for the S&P 500.
Sooner or later, bear funds will start appearing at the top of the mutual fund rankings. But market timing is a mug's game, and there are less risky ways to dampen risk. "I like to use more defensive stock strategies and bond funds/etfs to dampen volatility in down markets," Mr. Ebersole said. Unless you have a target for a hedge, such as a large stock holding, your client had better understand that there's no such thing as a perfect hedge, and that bear funds can be just as dangerous as bear markets. If you're not sure you need a bear market fund, you probably don't.