Investors sometimes panic when the stock market losses cross into bear-market territory, but there are a few investments that try to profit from losses.
Bear market mutual funds and exchange-traded funds are supposed to perform well when stock prices fall. Stocks are considered in a bear market when prices drop 20 percent in a given year. In 2018, the S&P 500 fell more than 6 percent, and the last true bear market was 2008, when the S&P 500 fell 38.5 percent.
Here are a few answers to common questions investors typically have about bear market funds:
— How do bear market funds work?
— How do financial advisors view bear-market funds?
How Do Bear Market Funds Work?
Many bear market funds will take a short position, selling borrowed securities or using derivatives, trying to profit when stock prices fall. Some of these short funds will use leverage to place steeper bets, while others don’t short stocks at all and use a combination of other alternative investments.
[Read: What Is a Bear Market?]
Some people invest in short funds to time when prices might fall, but most wealth advisors don’t recommend this strategy for the average investor except in rare instances.
Greg Swenson, co-portfolio manager for the Grizzly Short Fund (ticker: GRZZX) at The Leuthold Group, says their approach is to be close to fully hedged against the broader market at all times, using between 90 and 100 percent of short individual securities. The point of the fund, he says, is to do better than the inverse of the S&P 500.
“If the market is down 10 percent, we want to do better than being up 10 percent,” Swenson says about the fund in a down market.
Active money managers and people with a tactical view on stock prices are more likely to use GRZZX.
Swenson says, “They use it as a vehicle to capture and implement a negative market view,” or to try and take advantage of some mispricings in the market.
In-house tactical fund managers may use the Grizzly Short Fund to reduce stock exposure to avoid selling longtime equity holdings, which would otherwise trigger capital gains taxes, he says.
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“I don’t think most people are taking outright negative overall bets (with the fund),” Swenson says. “That’s pretty tough to do over the long term. I think it’s more of a vehicle to manage your long exposure.”
While most bear funds seek to short stocks, a newer bear-market focused ETF takes a different approach. Christian Magoon, founder and CEO of Amplify Exchange Traded Funds, the issuer of the Amplify Blackswan Growth & Treasury Core ETF ( SWAN), says the ETF uses 90 percent U.S. Treasurys and 10 percent S&P 500 call options.
“It’s for people who need the growth of equities, but they can’t afford to take a risk of a 15, 20 (or) 30 percent drawdown,” he says.
Because 90 percent of the fund is invested in U.S. Treasurys, Magoon says there’s a good chance that its bond portion could appreciate because bonds usually have an inverse correlation to stocks.
How Do Financial Advisors View Bear-Market Funds?
Bear market funds are not buy-and-hold investments, but are for short-term use, and that’s why many wealth advisors hesitate to recommend these investments to clients.
Steven Jon Kaplan, CEO of True Contrarian Investments, says investors need to think about how to position their portfolio if they anticipate a bear market, especially a severe one.
“Bear funds are fine during actual declines, but if there is no serious downtrend then you will often lose a lot in percentage terms,” Kaplan says.
Kathy Carey, director of research at Baird Wealth Management, says those who bought a bear market fund over the past few years because they thought a stock market pullback was likely probably lost money.
“From a timing standpoint it is difficult,” Carey says. “Over long periods of time, the market does tend to appreciate. So again, you could spend time in some of these bear-market funds and really be getting a negative return.”
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Morris Armstrong, owner of Armstrong Financial Strategies, says average investors generally don’t understand how leveraged ETFs work and recommends avoiding these vehicles. These funds might be better suited to day traders with a strong bias on market direction who exit positions quickly.
Steve Azoury, owner of Azoury Financial, says while investors should prepare for down markets, he prefers other ways to protect investors. Azoury recommends defensive stocks in sectors, such as consumer staples or health care; these sectors produce products that people use for every day life, such as groceries or medicine.
He also touts using gold funds or real estate investment trusts to limit stock market exposure during weak equity cycles.
Kaplan says rather than using a bear market fund, he prefers bonds, usually zero-coupon U.S. Treasurys and its funds including PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF ( ZROZ) and Vanguard Extended Duration Treasury ETF ( EDV).
“These gain more than most bear funds during bear markets and have much less risk if we end up not being in a bear market after all,” Kaplan says. “They also pay monthly dividends, which are free of state and local income taxes.”
Investors who worry about bear markets should discuss it with their advisor and review long-term money goals.
“(Bear funds are) really about being tactical and timing that downturn, versus having a plan and sticking with it, which over time has tended to play out for most investors,” Carey says.
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