Mutual Funds
for a Down Market
by Sy Harding, editor
Street Smart Report
Several
years ago, as the market began to become overvalued, experienced mutual
fund investors who had been badly burned in previous market declines, began
asking what they could do about keeping their profits, and maybe even making
more from the downside, when the next time comes. At the time there were
no mutual funds designed to make gains from the downside.
That
void has been filled in recent years.
Mutual
funds are now available with a variety of strategies designed to make profits
in a down market. In fact, most of them will only make gains in a down market.
Primarily
they do so by selling stocks short.
Selling
short consists of having a broker sell a stock you don't own, with the cash
being put in your account. How can you sell something you don't own? The
broker loans you the stock to sell (charging interest on the loan). Assuming
the stock declines in price, you then close out the position by buying the
stock in the open market at the lower price, and that stock goes to the
broker to replace that which you borrowed. It's the reverse of normal transactions
because you sold first and bought later, but the result is the same. You
bought low and sold high, and the difference is profit.
'Bear
market' funds that use such strategies include the Rydex Arktos Fund.
It's designed to move opposite to the Nasdaq 100, and is always 100%
short of those hundred stocks. It's therefore aggressive, as the Nasdaq
100 Index consists of the hundred largest stocks that trade on the Nasdaq
stock exchange, mostly hot growth stocks like Microsoft, Intel, Dell Computer,
etc. Those stocks have risen the most in the bull market, and in the process
have become the most overvalued by traditional measurements of valuation.
For instance, the Nasdaq 100 stocks are selling at an average of more than
100 times their earnings, while the S&P 500 is selling at 34 times its
earnings (which is itself an all time record).
So,
in a serious market correction, the Nasdaq 100 would have further to fall
to get back to fair valuation levels, and would theoretically produce the
biggest profits if sold short.
The
downside risk is obviously that, being the fastest rising index in the bull
market, if a serious correction does not take place, the Nasdaq 100 could
well continue higher, and the Rydex Arktos Fund will have commensurate losses,
not profits.
The
Rydex Ursa Fund is similar, but it's designed to move opposite to
the S&P 500. It also takes a different approach. It doesn't actually
sell the 500 stocks short. Instead, it utilizes so-called derivativesstock
and index options, and futuresto simulate being 100% short the S&P 500.
Some say its use of derivatives adds to its risk.
Less aggressive,
the Prudent Bear Fund uses a combination of some short sales, plus
holdings, like gold stocks, that it expects might rise in a general stock
market decline.So
there are a number of possible strategies for investors who believe the
bull market is due to cool off.One
is to simply hold on and wait for the market to come back. It always has,
but the risk is that it sometimes takes years to do so. It also risks the
tendency to bail out in disgust at the lows if losses become excessive,
and means that part of the next bull market is needed just to get back to
even.An
alternative is to move to cash and collect guaranteed interest until a decline
ends.But
for the first time, 1990's investors can opt for `bear market' funds that
offer an opportunity to keep current profits and move into holdings that
should make further profits from the downside, (realizing there is risk
that the downside will not materialize).Fortunately,
it doesn't have to be an all or nothing choice. A degree of risk management
might include a compromise; to hold onto promising holdings, raise and hold
some cash from holdings that have become the most overvalued, and switch
some holdings into funds that should make gains in a down market.We
are in the time period of such considerations. The market is in its most
vulnerable seasonal period, May to November, during which historically it
has suffered most of its serious declines, most recently including the 1987
crash, the 1990 bear market, and the milder corrections of 1996, 1997, and
1998.Editor's Note: Sy Harding is president of Asset Management Research Corp.,
169 Daniel Webster Hwy., Ste 7, Meredith, NH 03253, publisher of The
Street Smart Report Online at www.syharding.com, and the Street Smart
Report newsletter published every 3 weeks for $225 annually. A daily
Hotline is also available twice each day 9 a.m. and 7 p.m. via 1-900-820-2020
(2-3 min. messages @ $2.40/min.) Sy Harding is author of Riding the BearHow
to Prosper in the Coming Bear Market available at most book stores.
Mr. Harding is consistently ranked a Top Stock Market Timer, and Top Gold
Timer by Timer Digest.