Will Bear Funds Draw if Market Mauls?

With the Dow Jones Industrial Average hitting a record level of 13,000 in recent weeks, and three of the Russell U.S. equity Indexes, the Russell 1000, 2000 and 3000, also blasting through their previous ceilings in April, are investors worried the U.S. stock market has no place to go but down?

Moreover, will they head back to their favorite bearish mutual funds or seek out newer alternatives when the time comes?

Experts aren't convinced that a prolonged declining equity market is in the cards right now, despite escalating index levels.

"The Dow at 13,000 is just an index number and doesn't tell you anything about the valuations of stocks," cautioned David Reilly, director of portfolio strategy at Rydex Investments in Bethesda, Md. "Stocks to us do not appear to be expensive, but are also not historically cheap."

While Rydex isn't betting on a super bull market run, Reilly believes there's room for stocks to rally over the next quarter. Although the economy is slowing, he said, it's squarely positioned in the midst of a typical mid-cycle slowdown. Growth should also be driven by the containment of inflation and the Federal Reserve not yet ready to ease interest rates until probably late in 2007, Reilly noted.

Furthermore, it has yet to be seen whether financial advisers and investors will dust off the prospectus to their once-loved, bear-centric mutual funds. Today, they can instead choose all-weather hedged mutual funds that can short some positions, pile into leveraged inverse funds that seek to magnify returns in down markets, short any of the hundreds of U.S. equity exchange-traded funds available, or flock to short-ETFs.

Bear mutual funds perennially sell various stocks short with hopes of capturing a positive return as those stocks' decline. They borrow shares of the stock at current levels with hopes of buying back those stocks in the future at lower prices, then returning shares to the lender.

Perhaps ironically, the largest of the bear mutual funds ran an advertisement in one section of the April 26 issue of The Wall Street Journal just as another section carried a prominent headline announcing the Dow hitting 13,000. "That was purely an accident," conceded Rob Peebles, marketing director of the $680 million Prudent Bear Fund, advised by David W. Tice & Associates of Dallas. The fund had seen assets bloat to $692 million in March, up10% from $632 million at year-end 2006.

But the fund manager has a somewhat random approach at running ads in regional editions of the newspaper, and this one happened to coincide with the Dow's record, Peebles said.

"There are ETFs and every which way to short the market now," said Chuck Zender, co-portfolio manager of the $29 million, seven-year-old Grizzly Short Fund managed by Leuthold Weeden Capital Management of Minneapolis. "Allowing [investors] to hedge allows them to be more aggressive on the long side than they otherwise would be." Despite assets in his fund falling from a peak of $100 million, Zender doesn't believe his bear will become a dinosaur.

"There are a plethora of investments available today that weren't available even a few years ago," agreed Hugh Moore, a partner with Guerite Advisors of Greenville, S.C., the advisor to the four-month-old Guerite Absolute Return Fund, which expects to earn positive returns despite whatever direction the U.S. equity market takes. All-season funds like Guerite's have been created to appeal to investors who aren't spending lots of time tracking the market and can't be bothered shorting ETFs, but want less volatility and to avoid big market swoons, he added.

Bracing for the Bear?

Right now, investors aren't plowing the majority of their assets into products that short the market. Rydex, which offers a collection of long-only, short-only, leveraged funds and ETFs, isn't seeing a huge rush to short products, although the market's drop in late February caused a mini panic, Reilly said. Right now, assets in Rydex's long-only funds versus short-only/bear funds are four-to-one, indicating a positive sentiment, he added.

However, executives at Direxion Funds in Boston, advisor to 23 mutual funds including domestic and international equity bull and bear funds, as well as fixed-income bull and bear funds-some with the ability to leverage returns as high as 2-1/2 times the index they benchmark-saw some additional flows into the high-yield bear fund between the end of February and early March.

"A lot of assets stayed long, but that was accompanied by a strong bear sentiment," confirmed Ron Fernandes, chief executive officer of the fund group.

According to Lipper of New York, bearish mutual funds attracted only $486 million between the beginning of the year and March 31, after seeing consistent asset outflows over the last six months of 2006.

The jury is still out as to whether bear funds will claw their way to the top of the investment pile if and when the U.S. stock market sours. According to Morningstar of Chicago, there are 42 bearish mutual funds with a collective $4.4 billion.

At the beginning of the last bear market in 2000, there were only 55 domestic equity ETFs in existence, versus the array of 343 such ETFs now available for shorting. In addition, last June, ProShares, an affiliate of ProFunds, launched the first short- and leveraged ETFs, which as of April 30, have attracted $3.9 billion. Those assets "represent a significant sentiment on the short side," said ProShares Chief Executive Officer Michael Sapir.

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