Related topics: ETF, investing strategy, mutual funds, stock market, value stocks
Lately, some of the most popular fund managers in the stock market -- judging by where investors have put their dollars -- are those who bet against it.
So-called bear market mutual funds and exchange-traded funds, or ETFs, have benefited from an inflow of dollars this summer despite warnings by many investment advisers that the funds can be wrong for individual investors.
The bear market category includes a variety of approaches, but all are designed to profit when stocks fall. Many also use leverage, meaning they borrow in a way that can magnify gains and losses.
According to TrimTabs Investment Research, assets at bear market ETFs have risen $1.3 billion, or 8.3%, in the past three months. During that time, assets of bear market mutual funds, though much smaller than comparable ETFs, have gone up $33 million, or 2.34%, a larger percentage increase than any other domestic stock category.
Bear market funds have grown alongside bond funds, which pulled in $7.8 billion over the past three months. Meanwhile, investors withdrew a total of $13.1 billion from U.S. stock ETFs and mutual funds in the three months from May 21 to Aug. 24.
The growth has come despite concerns of regulators and investing experts. In August 2009, the U.S. Securities and Exchange Commission posted a warning on its website detailing the "extra risk for buy-and-hold investors" in leveraged and inverse ETFs, many of which fall into the bear market category.
But the funds have maintained their allure in a dicey market.
"When investor pessimism increases, (our fund) gets flows," says Ryan Bend, the portfolio manager of the Federated Prudent Bear Fund (BEARX), the largest bear market mutual fund. In the past 10 years, the Prudent Bear fund is up 9.1%, while the total return of the broad Standard & Poor's 500 Index ($INX) has been flat, according to Morningstar. Through Aug. 27, the fund was essentially flat year to date, while the S & P 500 had lost 4.5%.
Investor interest has intensified because of the European debt crisis, the May 6 "flash crash" and the general slide in stock prices, Bend says.
It's no surprise that investor behavior would follow such trends, says Michael Iachini, the director of investment manager research at Charles Schwab Investment Advisory. "Investors, for better or worse, tend to chase performance," he says.
The problem is that many individual investors are exiting stock funds only after they've fallen, thereby locking in losses and missing out on any potential recovery, Iachini points out.
Most bear market ETFs use derivatives to provide investors a daily return that is the inverse of a stock index's return. Amid the stock market slump of the past two years, such ETFs have proliferated, says Morningstar fund analyst David Kathman. "That's where a lot of the money has been going," he says.
Since the beginning of 2009, according to Morningstar, 37 bear market ETFs have made their debuts, and the remaining 67 ETFs in the category were all started since June 2006.
The trouble with leverage
Using leverage, many ETFs also magnify returns -- and losses -- two or three times. Thus the Direxion Daily Large Cap Bear 3X Fund (BGZ) provides returns three times the inverse of the large-cap Russell 1000 Index ($RUI). If the Russell 1000 falls 1%, Direxion investors get a 3% positive return. Conversely, if the Russell 1000 rises 1%, Direxion investors see a 3% drop.
Another serious concern about many bear market funds is they are better suited for short-term traders rather than long-term investors.Inverse ETFs don't reliably track their indexes over the long term, Direxion and other ETF operators concede. ETF operators must rebalance their portfolios each night, a process that can create a large "tracking error" over several days and hurt long-term returns.
"We cater to short-term investors," says Paul Brigandi, a senior portfolio manager at Direxion. The funds are for "sophisticated investors who have time to monitor and manage the portfolio on a daily basis."
