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Think twice before you invest in a bear-market fund

If you go to the dark side, make sure you have a plan.

  • By Chuck Jaffe,
  • MarketWatch
  • – 07/14/2014
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Market milestones — like Dow 17,000, the recently broached record high for the Dow Jones Industrial Average (.DJI) — tend to bring out the doomsayers, the guys who believe that every breakthrough is one step closer to a turning point.

As a result, a raft of prognosticators has come out in the last few weeks saying to expect everything from a mild downturn (buying opportunity) to a reason to protect profits and move to cash to a looming decade of financial pain and misery.

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It's enough to get investors thinking about buying a bear-market fund.

For most people, however, that's the wrong move, not because the market can ride indefinitely, but because the average investor not only misuses bear-market funds but has horrible timing while doing it.

More than other fund types, bearish funds play on those foibles.

Speaking simplistically, bear-market funds should make money when the market is going down; they come in a variety of flavors, allowing investors to simply act as if they expect a downturn or to use leverage and double-down on a market drop, trying to turbocharge their gains while the rest of the market feels its pains.

Many money managers who run bear-market funds, however, say their products aren't built so much for profiting from a market decline as they are to protect and hedge against one, diversifying risk; anyone with the urge to bet against the market short-term can use leverage and inverse funds to make short-term moves, but the real point of holding a bearish fund for more than a day or two is that keeping a steady allocation to the dark side is a way to have something positive at times when everything else appears to be in the tank.

Brad Lamensdorf, who runs the AdvisorShares Ranger Equity Bear ETF (HDGE), an actively managed exchange-traded fund, noted that there are three types of investors who buy bear funds.

"There are the people who time the market, who have their statistical proof that they believe will lead to a better risk-adjusted return, and they are using bear funds to execute their moves in and out of the market," Lamensdorf said.

"Then there is the professional allocator, who is using a bear fund to diversify their risk, and every quarter or year they look at their allocations and re-set to them," he added. "They're not just letting their Standard & Poor's 500 (.SPX) allocation move from 40% of their portfolio to 50 or 60% just because the S&P has done well over the last two years.…At every step along the way, they are harvesting gains and reallocating to stay on their plan."

The third kind of investor is the most common, and the one who Lamensdorf and other bear fund managers really don't want to see in their funds, because they are "emotionally charged people moved by headlines or what is happening now, without really having a plan."

In short, this third group is the average investor who is inspired by bad-news headlines and nervous market calls. They're chasing performance, most likely with an investment whose strategies they don't completely understand (it is worth noting that most bear funds carry above-average costs, simply because of the strictures of betting against the market).

For investors who want to avoid being sideswiped by their own emotions, it's best to consider bearish funds as portfolio insurance, protection for some future rainy day, rather than a way to cash in on the market's painful moves or trends.

Funds that bet against an index can be harder to hold in all conditions because their construction means they will go down whenever the index is up; that makes them particularly tough to hold when the market has been running strong.

Actively managed bear funds try to profit by picking the losers that exist even when the market is up. Those funds tend to be atop the bear-market category now, because they're not working against the full tide of the market.

Of course, investors can self-insure their portfolio by holding more cash or allocating money away from stocks and into alternative asset classes.

That's why investors who are looking at Dow 17,000 and finding that the number raises fear in their hearts might consider whether they really have the stomach to own a bear fund. Failing to take that step now — waiting instead until bear funds look promising not just because of some scared market-watchers but because the daily declines are starting to mount — is emotional investing, poor timing and improper allocation.

Most investors won't be able to make the move to the dark side, and that's probably the right choice.

"Bear funds definitely aren't for everybody," said Lamensdorf, "and if they're not right for you, it's better to know that than to buy one and find out later that you aren't cut out for this kind of investing."

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