Fund Focus: Bear Funds Come Roaring Back as Market Rally Slides

It's hard to know how to pick a decent mutual fund at a time like this. After all, why would you want to put your money into an index-based fund when all the benchmarks they cling to look like they're headed down the drain? And why would you want to pay the higher fees that actively managed mutual funds charge when the relatively small number of stocks they include could fall even faster than the benchmarks they are trying to beat?

Enter bear funds, which do two things: rise when the market is falling, and fall when the market is rising. Their fees may not be cheap, but they tend to make money at times like these. They did well from the second half of 2007 to the first quarter of 2009, when the U.S. stock market plunged deeper than ever since the Great Depression. Then, when the market rallied from the second quarter of 2009 to the first quarter of this year, bear funds lost money.

But since April 26, when the rally started to slide off a cliff, with more than a little shove from the Europe debt crisis and the unemployment scare in America, bear funds have been looking like the smartest investments on the planet.

Betting Against the Market

How do bear funds work? They short stocks, meaning they sell stocks they don't yet own in the belief that the prices will fall. To do this, they borrow stocks from their brokers, sell them, and then replace them by buying them later at a lower price.

These funds have done more than just protect their client's investments over the last nine weeks. In fact, they were among the best performing mutual funds during this period. In other words, some bear funds are not just beating the Standard & Poor's 500, but are actually making money for investors.

Of the 50 funds that delivered the highest total returns between April 26 and June 10 -- excluding exchange-traded funds -- 33 mutual funds were classified as "dedicated short-bias" funds by Lipper, a unit of Thomson Reuters (TRI) in Denver that tracks mutual funds. "They are all shorting the market," says Lipper research manager Jeff Tjornehoj, who compiled the list.

The names that appear repeatedly on this list are those of large fund families like Direxion Funds, Rydex Investments and Profunds, while smaller shops like Comstock Partners and Leuthold Weedly Capital Management also claim several spots.

Top Performer: Expect Volatility

The top performer, the Direxion Monthly Small Cap Bull 2x Fund (DXRSX), was up a stunning 31.92%. The index fund is leveraged -- meaning it uses instruments such as debt or derivatives to boost the amount of shares it owns -- by 200% and seeks to beat the monthly returns of its benchmark, the Russell 2000 Index, by 200%.

Of its modest $27.8 million in assets, the fund's largest allocations are in financial services (22%), consumer discretionary (16%) and technology (16%). It's managed by a team of quantitative analysts at Rafferty Asset Management, a quantitative investment firm in Boston, who rely largely on software to pick stocks instead of visiting the companies they invest in. Because it's an index fund, instead of an actively managed fund, the fees -- at 1.86% -- are lower than you would expect for an active short fund.

But you can also expect this Direxion fund to be even more volatile than the average bear fund for a couple of reasons. First, the companies in that particular Russell index are small, which means their stock prices tend to move around a lot. Second, the use of leverage amplifies the rise or fall of fund's performance – in this case, by 200%. Still, because it seeks monthly returns instead of daily ones, the fund isn't nearly as volatile as leveraged exchange-traded funds at Rafferty, which actually warns individual investors away.

Validation for Pessimists

In general, the managers of the actively managed funds on the Lipper list – that is, the folks who take the trouble to visit or at least read about the companies they invest in – tend to be doomsday theorists. It can get a little scary to hear them lay out their gruesome investment theses explaining why they're convinced the worst is yet to come.

Take Charlie Minter, a co-manager of the Comstock Capital Value Fund (DRCVX), which rose a mere 11.88%, ranking 22 out of 50 funds on the list. Based in Yardley, Pa., Minter believes the stock market is falling in response to a widespread, well-placed fear that the combination of public and private debt will lead to a prolonged period of deflation as prices for American products fall, further depreciating the dollar.

He estimates total public and private debt at $55 trillion -- about four times the U.S. gross domestic product. One of the $164 million fund's most lucrative investments thus far, he says, is a short position on Goldman Sachs (GS) stock.

"What is taking place is that the debt of this country has become overwhelming. We are going to wind up just like Greece," he warns. Greek debt woes triggered the Europe debt crisis this spring, which contributed to the current U.S. stock market slump.

But remember: Any bear-market fund doing well steps a little closer to its own doomsday when the market turns back up. If you ever invest in one, your first challenge will be to withdraw while the market is still falling -- or at least still bottom-crawling.