Mutual funds that bet against the market or a sector of the economy are also known as bear market funds. A bear market is one in which stock prices across the board suffer a general decline, as opposed to a bull market when stock prices as a whole are steadily increasing. Some bear market mutual funds short stocks in an attempt to time the market as a hedge against losses.
How It Works
Many mutual funds that bet against the market track a benchmark in reverse. Fund managers sell short index futures or stocks that make up an index in an inversely proportional weight to that of the benchmark. Investors short stocks by borrowing shares, then selling at a price with intentions of buying shares of the same stocks back at a lower price. Instead of the usual buy-low-sell-high approach, the investor sells high, then buys low.
Bob Frick, senior editor of "Kiplinger's Personal Finance" magazine says that bear market funds extremely risky and adds that investors must be very lucky or sophisticated to profit from the funds. What Frick calls the best of the actively managed bear funds earned 1 percent over a five-year period, during which aggregated stock earnings in Standard & Poor's 500 Index returned an annualized 10 percent.
During a down market, prices of certain stocks may rise uncharacteristically as hedge fund managers purchase shares of stock to repay lenders when borrowed stocks from short positions come due. This can affect returns on mutual funds that bet against the market when it is in decline. The expense ratios of bear market funds take a 1.5 to 2 percent cut in profits upfront. In addition, bear market funds do not pay dividends. Instead if the fund is shorting stocks, dividends on the borrowed shares must be paid to the lender from the assets of the fund, further decreasing profits to shareholders.
Historical performance of long-term investing in stocks, is the main reason not to invest in mutual funds or other investment products that bet against the market. This is because for long-term investing, stocks produce the greatest returns. Investors who purchase shares in bear market funds should have no more than 5 percent of their total portfolio in such products, and then only to hedge against a major loss.
Vicki A Benge began writing professionally in 1984 as a newspaper reporter. A small-business owner since 1999, Benge has worked as a licensed insurance agent and has more than 20 years experience in income tax preparation for businesses and individuals. Her business and finance articles can be found on the websites of "The Arizona Republic," "Houston Chronicle," The Motley Fool, "San Francisco Chronicle," and Zacks, among others.