It would appear that corporate cost cutting and a string of positive economic data are putting investors in a sunny mood again. Take, the Nasdaq, for example — it's up by 40 percent this year. But before you chuck out all those bear funds that you wove into client portfolios to dampen the pain, remember that what cost investors so dearly in the first place was too much risk. Many clients were simply overloaded on equities in general and concentrated in too few and too volatile holdings in particular.
Not surprisingly, bear funds — which trade futures or sell stocks or bonds short — surged in popularity during the last few years. So popular, in fact, that Morningstar created a separate bear category (covering 18 funds) and even annuities began offering bear strategies.
One way to avoid leaving your clients fully exposed to equity and bond risk is to continue to use bear funds as a hedge. In fact, bear funds can make intriguing vehicles that fine-tune risk levels. By coupling the bears with their cousins, leveraged funds — which make outsized bullish bets — investors with limited pocketbooks can develop strategies that resemble the techniques of sophisticated hedge funds.
Lately bearish bond funds have proved particularly useful. Consider a conservative retiree who relies on bond funds for income. When interest rates rise, bond funds fall. And with rates now low and rising, the retiree worries that his nest egg could be eroded in the next few months. The investor could simply sell the funds and put the cash in money markets. But that could produce big capital gains tax bills, and the subsequent yields would be tiny. Another approach is to keep the bond funds and buy a stake in a bearish bond fund, such as Rydex Juno. That fund rises when 30-year Treasury bonds fall. Say the investor has $100,000 in intermediate-term funds with a duration of five years. If rates rise by 1 percentage point, the portfolio would lose about $5,000.
As an insurance policy, the investor could put $25,000 into Rydex Juno, which has a duration of -14. (The negative duration indicates that the fund would react to interest rate shifts by moving in the opposite direction of Treasury bonds. So when rates rise 1 percent, Juno would typically return about 14 percent, for a gain of $3,500.) Like any insurance coverage, the bear fund comes at a cost. The annual expense ratio is 1.4 percent, and, of course, if rates fall, Juno would suffer.
Bear funds can be used to protect a variety of bond portfolios, says David Eachus, a registered investment adviser in Clearwater, Fla., affiliated with Raymond James Financial Services. To hedge a client's junk bond position, Eachus recently used Rydex Juno. Junk bonds do not rise and fall precisely in line with the Treasuries that Juno tracks. But when rates rise, junk often can be hurt, so Eachus took 10 percent of the assets from the junk funds and put them into Juno. “The client liked the income he was getting from the junk funds, but he was afraid of volatility,” Eachus says.
Even clients who aren't worried about hedging bond portfolios can use funds like Rydex Juno, says Ted Blood, a partner with Capital Wealth Management, a registered rep in Scottsdale, Ariz., that is affiliated with First Financial Equity Corp. Inverse bond funds like Juno follow unusual paths, never tracking bonds and rarely moving in lockstep with stocks. That makes the funds ideal diversifiers, says Blood. Some of his aggressive clients have few bonds and most of their assets in stocks. To balance the mix, Blood puts about 15 percent of their portfolios in Juno. “Juno diversifies the portfolio, and it could produce nice returns if interest rates keep rising,” he says.
|CFund||Ticker||Objective||One-year Return||Three-year Return||Expense Ratio|
|Potomac OTC/Short||POTSX||Inverse NASDAQ 100||-35||11.8||1.90%|
|ProFunds UltraBear||URPIX||Double inverse S&P 500||-30.3||13.6||1.79|
|ProFund UltraBull||ULPIX||Double S&P 500||10.3||-28.5||1.93|
|Rydex Juno||RYJUX||Inverse 30-year Treasury||-4.5||-5.7||1.41|
|Rydex Ursa||RYURX||inverse S&P 500||-13.7||11||1.30|
|* Also trades OTC|
|Source: 3/25/03 data from Merrill Lynch, TDWaterhouse.com and Fidelity.com|
Like their bond-market cousins, bear stock funds can help to limit downside risk. The stock funds follow a variety of approaches. Some simply sell selected stocks short. Others provide the inverse of an index, such as the S&P 500 or Russell 2000. By using one of the index offerings, it is possible to build a targeted hedge. Say a client owns a broadly diversified stock portfolio. Convinced that technology stocks are again forming a bubble, he talks about dumping all his holdings. To provide the comfort the client needs to stay in the market, the advisor could suggest sticking with the diversified stock funds and putting a chunk of assets into a fund like Potomac OTC Short, which rises when the tech-heavy Nasdaq 100 falls. By including long and short positions, the portfolio could resemble a hedge fund — with an important difference. While hedge funds require steep minimum investments, opening an initial account at Potomac takes as little as $10,000.
Another recipe for a nervous investor could include a leveraged bull market stock fund, which performs the opposite function of the bear market specialists. Say the adviser decides that a client should invest 40 percent of assets in an S&P 500 index fund. Still hurting from the market downturn, the client hesitates to put so much cash back into the market. As an alternative strategy, the shaky investor could put 20 percent of assets into a money-market fund and 20 percent into a leveraged choice such as ProFunds UltraBull, which returns double the results of the S&P 500. Both the index fund and the Ultrabull could represent similar stakes in the stock market. To be sure, the bullish funds could suffer badly in a down market, but the losses could be cushioned in a diversified portfolio. “When the client knows that 20 percent of his assets are completely safe, then he feels comfortable about taking some risk,” says Michael Sapir, chairman of ProFund Advisors.
After considering bear funds, some advisers conclude that they prefer to construct a customized hedge themselves, perhaps shorting individual stocks or exchange-traded funds. These approaches have proved effective during the recent downturns. But bear funds have some important advantages. For starters, government rules prevent shorting stocks in a retirement account, and bear funds can be used anywhere. In addition, selling short requires setting up a margin account and paying brokerage commissions. For someone who simply wants to hedge for a few months, a no-load bear fund could be cheaper. Perhaps the most important advantage of the bear funds is that they are, after all, mutual funds. Funds have long been popular because they are convenient and easy to use. Clients are comfortable with funds. That is no small consideration. Because a primary goal of hedging to is produce a portfolio that will enable an investor to sleep comfortably — even when the bear emerges.