From the July 2008 issue of Research Magazine • Subscribe!

Summer Rout Boosts Bear ETFs

One look at the stock quotes on your computer screen reveals a not so subtle theme: Red all over the place.

The generally accepted definition of a bear market is a 20 percent decline over at least a two-month period. And by that measure, the U.S. stock market is within striking distance.

Exchange-traded funds (ETFs) tracking the Dow Jones Industrial Average (DIA) and the S&P 500 (SPY) are in the vicinity of bear market territory. So far this year, DIA has declined by 15.3 percent and SPY is off by 14.3 percent.

The decline in stocks hasn't been bad news for everyone.

Spiraling stocks have fueled the performance of bear-market ETFs, which are designed to increase in value when the securities they track fall. These types of funds are also referred to as "short" or "inverse" funds.

The ProShares Short Dow 30 (DOG) is up 15.8 percent through July 10 and the ProShares Short S&P (SH) has jumped 15 percent since the beginning of the year. (ProShares is affiliated with ProFunds Group, which also offers mutual funds that have similar short strategies.)

RydexShares is another lineup of inverse performing ETFs. The Rydex Inverse 2x Russell 2000 ETF (RRZ) which moves in the opposite direction of small-cap stocks, has climbed 20.8 percent.

The performance of bear-oriented ETFs has been exceptionally good in hard-hit industry sectors like financials and technology. The ProShares UltraShort Financials (SKF) is up 67.2 percent, and the UltraShort Semiconductors (SSG) is up 31.7 percent. Both funds use leverage to double their daily inverse performance.

Despite the stellar performance of bear ETFs so far this year, caution is in order.

The long-term performance record of funds that short the market isn't pretty. Since its inception in 1997, the record for the Bear ProFund (BRPIX), which goes opposite the S&P 500 is negative 1.96 percent, through the end of the second quarter.

Where might bear funds fit into your client's portfolio strategy?

The first priority for most investors should be to build a portfolio that can thrive during any kind of market. This can be achieved by having exposure to major asset classes -- like domestic and foreign stocks, corporate and government bonds, commodities, REITs and cash. You can find low cost ETFs covering each one of these areas by searching each of these categories using ETFguide.com's online database, for instance.

After you've built a portfolio on a solid foundation and a diversified mix, any extra money available for riskier investing could potentially go into bear-market ETFs.

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