THINK THIS MARKET

is a bummer? It all depends on your perspective. While the average U.S. stock fund is down a dismal 15.6% over the past year, not all funds are languishing. In fact, for some, things have never looked brighter.

"I have never been more confident in my life that we will head much lower," says fund manager David Tice. And for this manager, that's good news. That's because Tice runs the Prudent Bear fund one of a small group that's positioned to do well when the stock market heads south. Over the past year, this fund has gained 61.6%, according to investment-research firm Morningstar. And Tice believes there's more opportunity ahead. "We don't see business getting better," says Tice. "We think many businesses are still dramatically overpriced."

Indeed, bear-market funds which mostly use short-selling techniques to profit from stock-price declines are now offering the types of returns seen by growth funds in the late 1990s. For the dozen bear funds we've included in the table below, the average one-year return is a stunning 40%. And while tracking fund flows for bear funds is difficult (since money moves in and out of these funds rapidly), it appears that investors are gaining interest in this group. As of April 30, $93.9 million had flowed into the 11 bear funds tracked by the Financial Research Corporation, compared with net inflows of $11.5 million during the same period in 2001. Fund flows "have been pretty strong," says Charles Tennes, director of portfolio management at Rydex Funds, which launched its first bear fund in 1993 and now offers four. "From 1993 to 2000 these funds weren't attracting much attention," says Tennes. "But every dog has its day."

The Bear Essentials
So does a bear fund belong in your portfolio? Despite the gloomy market outlook, the answer is almost assuredly "no." "There are some niche uses for these funds, but it doesn't make sense for a core component for a long-term portfolio," says Alan Papier, mutual-fund analyst at Morningstar.

The reason: Over the long haul, the stock market goes up, not down. Don't believe us? Take a look at this chart, which shows the performance of the S&P 500 over the past 72 years. As bleak as the past few years have been, there's no reason to think that the broader stock market will forever move in the reverse direction. This means that the longer you hold a bear fund, the more likely you are to lose money in it. "Look, if you invest in my fund, you need to understand that you have to sell it," says Chuck Zender, co-portfolio manager of the Grizzly Short Fund.

But aside from offering bearish investors an opportunity to try to time the broader market or a specific sector (and I'll address the foolishness of that below), bear funds do have a purpose: They can be used to hedge long positions in your portfolio. Indeed, when used correctly, a short fund can be used to reduce the short-term risk of your portfolio, rather than increase it.

An example will show you how this works. Imagine, if you will, that you just found out that your daughter was accepted to Dartmouth College. You know that this spells staggering bills for the next four years but you're ready. For the past 17 years, you've been diligently contributing to a college fund that consists of equity mutual funds. Now, with this deadline finally nearing, you know you can't handle substantial losses. At the same time, you don't want to sell quite yet, since selling will lead to a large capital-gains hit something you'd hoped to push off until the next tax year. So to hedge against substantial short-term losses, you buy a fund that shorts the S&P 500. This way you know that either your long or your short position is probably going to lose money but at the same time, the hedging will create a balance, which means that no matter what the market does, you won't lose big.

Sound complicated? It is which is why only sophisticated investors should consider bear funds. Nevertheless, "there is a compelling argument for some people to do this during some occasions," says Morningstar's Papier.

Entering Bear Country
Bear funds essentially come in two different breeds: There are those that track specific indexes (like the Nasdaq 100 and the S&P 500), and then there are those that are actively managed with a hand-picked portfolio. (A totally different animal is the long-short fund, which has both long and short positions in its portfolio and isn't specifically geared to perform well in bear markets. Click here

The funds that track the indexes are 100% short. Within this collection, a handful are additionally leveraged, so they offer twice the inverse return of the index they track (i.e., if the S&P 500 loses 5%, a fund seeking twice the inverse return would gain 10%). Clearly this is very risky business indeed, but they do allow investors using a bear fund as a hedge to put up less money, explains Michael Sapir, chairman of ProFunds, which offers several bear funds.

Some actively managed funds like Tice's Prudent Bear fund hold both long and short positions as well as some bonds. For example, Tice is currently long on gold stocks, which have done well as of late. The Grizzly Short Fund, on the other hand, is a 100% short fund.

There are even a couple of bear bond funds out there. These unusual funds are positioned to do well during periods of rising interest rates a time when long bond portfolios do poorly. Rydex's Juno fund offers the inverse daily price movement of the 30-year Treasury bond, while ProFunds' new Rising Rates Opportunity fund (sorry, no snapshot available) uses additional leverage to provide 125% of the inverse of the price movements of the 30-year Treasury. These funds will not, however, perform well in a typical bear market, when standard bond portfolios tend to do well.

Bear Bottom
So what if you simply have a strong hunch that this market is still heading down? Given current investor sentiment, hibernating in a bear fund's den might not sound like such a bad idea. These are uncertain times, and while the economy may be recovering, some market prognosticators including the Chief U.S. Strategist at Merrill Lynch, Richard Bernstein say that this market has yet to touch bottom.

But as our columnist James Stewart wrote this week on SmartMoney Select, identifying a market bottom is no easy task so you shouldn't bank on being able to do so successfully. It's also worth noting that while these funds have done very well over the past couple of years, they won't continue to outperform in a flat market. "We need a trend," says Grizzly Short's Zender.

Bottom line? Don't chase the returns of these funds. Bear funds have their purpose, but they also have very sharp claws.