What Are Bear Funds?

Most investors focus on owning stocks with the expectation that they'll rise in value. During bull markets, that strategy works very well. When bear markets strike, however, owning stocks is often painful.

Bear funds can help those who want to make money when stocks fall, because they're designed to have their prices rise when the market declines. The market has done so well recently, and bear funds have gotten crushed lately, but investors stand ready to reap rewards if the market turns.

Notable bear funds

Data source: Fund providers.

How different bear funds work

There are a couple of different ways that most bear funds structure their investments to benefit from falling markets. Index-based bear funds use derivatives to produce a daily return that's equal to the inverse of the return of the target market. For instance, with the Short S&P 500 fund above, if the S&P 500 drops 2%, then the assets held by the fund should rise in value by 2%.

By tailoring derivative exposure, you can also get leverage through bear funds. The UltraShort S&P 500 ETF is a two times leverage bear fund, meaning that a 1% decline in the S&P 500 should produce a 2% rise for the fund shares. Funds that look at a variety of different tracking indexes are available.

Other bear funds use active management strategies, seeking to take advantage of the most overvalued markets. The Prudent Bear Fund has short positions in ETFs that track the S&P 500 and Russell 2000 small-cap index, as well as certain sectors such as energy and industrials. Interestingly, it also has long positions in certain individual stocks, with the idea that the fund anticipates that those stocks will outperform the overall market, or their respective sectors.

Grizzly Short Fund uses an individual-stock approach, but it doesn't typically use long positions. Instead, the fund has 77 different stocks that it has sold short, with information technology and industrials being the sectors with the biggest short positions.

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The dangers of bear funds

For short-term purposes, bear funds can be extremely valuable. Bear markets tend to be shorter than bull markets, but they are also often much more violent in their movements. As a result, if you get the timing right -- and that's a huge if -- then owning bear funds tactically can let you profit from bear markets and protect the rest of your portfolio from declines.

The problem with bear funds is that their track records over the long haul are poor. From year to year, stock-market returns can be positive or negative. Over periods of a decade or more, it's rare for stocks to post declines, and over longer periods, they're nearly unheard of.

Moreover, some bear funds use strategies that don't lend themselves well to long-term investors. Index bear funds that use derivatives can lose ground even in flat markets because of the tactics they employ and their relatively high expenses.

Should you own bear funds?

If you're planning to bet against the market, then owning a bear fund has some advantages over more aggressive alternatives. Bear funds are safer than having short positions in stocks, because losses are limited. You can also invest retirement-account assets in bear funds, even though you can't short stocks in a retirement account.

As long-term plays, bear funds rarely make sense because of the overall upward trajectory of the market. For tactical positions that you don't expect to hold for a long time, however, bear funds can be useful.