If you can't beat 'em, join 'em. That's the philosophy behind dozens of mutual funds and exchange-traded funds that make bets against the stock market. The returns of these so-called bear-market funds have looked awfully attractive lately, when most investors are looking at losses from many of their investments.
The real question, though, is whether bear-market funds deserve a permanent place in your portfolio. As we discuss in more detail in this month's issue of The Motley Fool's Champion Funds newsletter service, which is available today at 4 p.m. ET, most investors in these funds can expect to see losses from these funds over longer time periods.
Just as funds use dozens of strategies to make money from rising stocks, different bear-market funds try to earn profits in a variety of ways in volatile markets. In general, however, bear-market funds are designed to take advantage of market downturns by making investments whose value goes up when stock prices decline.
Bear-market funds fall into two broad categories. One group actively manages its portfolios by selling stocks short -- picking companies whose stock prices are expected to fall. On the other hand, an increasing number of funds and ETFs use an index-based approach to betting against the market, by using derivatives such as stock index futures and options to achieve returns based on the performance of popular market benchmarks. Depending on the method used, you can find funds that will give you a return of 2% or more for every 1% drop in a given benchmark.
Short-term gain, long-term pain
As you'd expect, recent market volatility has breathed new life into bear-market funds. The top-performing funds over the past year have made leveraged bets against the Japanese stock market or small-cap domestic stocks, leading to returns of 20% to 50% in some cases. According to Morningstar, the average bear-market fund is up more than 3% in the past 12 months, compared to a loss of about 7% for the S&P 500.
On the other hand, however, a look at long-term results in the category show that bear-market funds haven't held up well. Looking at 10-year returns shows that only a single fund, the Prudent Bear fund (BEARX), has a positive return. To generate those returns, Prudent Bear has been successful in two ways. First, it has made some astute short-sale picks, including Whole Foods Market (Nasdaq: WFMI ) , Starbucks (Nasdaq: SBUX ) , and General Motors (NYSE: GM ) .
At the same time, Prudent Bear has bought into the precious-metals sector, which has performed well in gold's bull market. Miners such as Newmont Mining (NYSE: NEM ) and AngloGold Ashanti (NYSE: AU ) have helped out with positive returns in recent years.
Meanwhile, most bear funds have lost substantial amounts, despite a fairly weak performance from stocks. Even with a relatively lackluster 2% average annual gain in the S&P 500 over the past decade, the average bear fund is down more than 4% per year.
Swimming against the current
As a short-term speculative play, bear-market funds can be a useful tool to protect your portfolio. While taking profits on your long-term holdings can create huge capital gains tax liability, buying a bear-market fund with a negative correlation to your other stock holdings can hedge against losses.
As a long-term investment, however, bear-market funds suffer from the simple historical fact that stocks have tended to rise substantially over time. With stocks returning around 10% on average, bear-market funds essentially start out with a 10% handicap. In addition, when funds short-sell high-yielding stocks such as Citigroup (NYSE: C ) or Pfizer (NYSE: PFE ) , they also have to pay the additional cost of reimbursing dividends.
As long as the stock market continues to be choppy, bear-market funds will retain their popularity. But even though they've put up some nice results lately, you're better off keeping them out of your permanent portfolio.
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