The Bears Are Back

With stock indices well off their highs of last year, the bears are back in vogue, once again making dire predictions of market performance for the years ahead. Of course, such prognostications are nothing new.

However, this time around the predictions of an enduring bear market are harder to ignore. Bears argue that by lowering interest rates earlier this decade as a result of the 2001 recession, the Federal Reserve put off pain at the expense of only more anguish later. Their argument: Low rates helped fuel the credit bubble, leading to a mania in residential real estate even worse than the hysteria of the dot-com boom.

No doubt the trend has been downward this year, and bear market funds, which are designed to capitalize on a slumping market, are enjoying the moment. Through mid-April, with a return of 9.3%, bear funds were the top-performing fund category, according to Morningstar. Bear markets are defined as declines of 20% or more over a 12-month period or less. By mid-April, the Dow was 13% off its high of more than 14,000 last October. Yet other indices are already well into bear markets: the S&P MidCap index and Russell 2000 are off more than 20% since last summer.

“We think we’re at the early stages,” says David Tice, manager of the $1.2 billion Prudent Bear fund. “We can easily see declines of 50% to 60%.” For some protection, investors can turn to bear funds. There are actively managed funds, such as Prudent Bear and Comstock Capital Value Fund. Prudent Bear mainly shorts individual stocks (betting against a stock on the belief that its share price will fall) — these days equities such as consumer discretionary companies, home builders, financials, and technology companies. Comstock also makes both short and long bets. It shorts stocks in similar industries to Prudent Bear, while also betting against retail and industrial stocks.

Investors can also buy passively managed mutual funds that aim to produce a multiple, typically one to 2.5 times, of the inverse performance of the index they’re measured against. Or investors can tap a range of bear ETFs.

A few caveats: bear funds tend to be more expensive — bear fund fees are in the range of 1.75% to 2% of assets per year, according to Morningstar (though ETFs offer a cheaper way to go). The higher expenses relative to long mutual funds and ETFs is in part due to the higher costs of shorting, says David Kathman, a mutual fund analyst at Morningstar.

The other warning is that investors in bear funds need to know what they’re doing, Kathman says. Just chasing returns could get newcomers into trouble, particularly if the market turns around. “If the market goes up, bear funds will get hammered,” he warns.

TOPPING THE CHARTS