Investors Still Jumpy About ‘Short’ Funds

What if they had a rally and nobody came?

That’s been the case with many “short” mutual funds, which mostly earned handsome returns in 2000 by selling stocks short--that is, betting against the market.

ProFunds UltraShort OTC, for instance, soared 69% in the fourth quarter and Rydex Arktos surged 41%, as the Nasdaq composite index was sinking 33% in the same period.

Yet investors have been moving money out of most short funds, even before the rebound in the Nasdaq market began this year.

That’s a far cry from what usually happens in the mutual fund industry--which is that investors chase the most recent top performers.

Short funds have multiplied in number in recent years. They are marketed as a way for aggressive investors to make a near-term bet on a stock market drop and as a hedging tool for more conservative investors who want to own something that can offset other portfolio losses in a down market.

But the funds have a limited audience, analysts say, in part because they go against the average investor’s bullish nature--not to mention the market’s long-term upward trend.

Typically, managers of short funds buy “put” options and/or sell short futures contracts based on indexes such as the blue-chip Standard & Poor’s 500 or the technology-heavy Nasdaq 100.

A put option gives the buyer the right to sell a specified number of shares in a stock or index at a set price by a certain date. So it is, in effect, a bet on a subsequent decline in price.

A short-sale of a futures contract or individual stock works the same way: The investor is borrowing the security, and selling it, betting it can be replaced later at a lower price.

Though most short funds are index-oriented, in some cases the fund managers can also sell individual stocks short.

Short funds also can use leverage, or borrowed money, to boost their potential returns.

The downside is that if the market rises instead of falls, leveraged funds’ losses are magnified as well.

Many short funds are designed to produce 100% to 200% of the inverse performance of the base index, depending on how much leverage they use. So, if the S&P; 500 loses 3% on a given day, funds that are heavily short the S&P; may gain up to 6%.

With last year’s market losses, most short funds produced positive returns, as expected.

But many investors in the funds were already bailing out late in the year.

Michael Sapir, chairman of Bethesda, Md.-based ProFunds Advisors, said his firm’s three short funds had an aggregate outflow of $62 million in the fourth quarter, including $40 million in December, despite their heady returns.

Sapir called it a matter of profit-taking. “People simply did well and took money off the table,” he said.

The funds’ current assets total about $85 million.

Anna Haglund, spokeswoman at Rockville, Md.-based Rydex Funds, said the firm’s four bearish offerings had an aggregate net outflow of $89 million in the quarter. Current assets in the short funds total about $320 million.

Investors who sold short funds late last year look smart, for now: Most of the funds have lost ground this year as many stocks have rallied.

Some analysts question whether most investors should ever consider these funds, even as modest hedge positions in their portfolios. In the first place, it may be tough emotionally for many people to make such a pessimistic bet.

“Let’s face it: American investors are intrinsically optimistic,” Sapir said. “Betting against the market goes against the grain for most people.”

Carl Wittnebert, research chief at Santa Rosa, Calif.-based fund tracker TrimTabs.com, said last year’s 17.4% gain by Rydex Ursa, which aims to produce the opposite daily returns of the S&P; 500, “was excellent, but not what myths are made of. What gets people’s imagination going is the hoped-for resumption of the Nasdaq rally--the idea that you might be able to make 100% or more.”

Investors were probably lured out of short funds in the fourth quarter by various psychological “hooks,” said Todd Salamone, head of research at Schaeffer’s Investment Research in Cincinnati.

“First it was the seasonality argument: The market has historically bottomed in October,” he said. “Then came the presidential election and the general feeling of, ‘I don’t want to be out of this market now. When the election is finally settled it will take off again.’ ”

Some advisors say investors whipsawed by market gyrations in the last year may also be wary of the downside of short funds, which can get creamed in rallies, especially if they are leveraged.

“If you’re wrong on the long side you’re probably going to get mediocre results, but it’s not likely to be too harmful. If you’re wrong on the short side you can really get hurt,” said Paul Merriman, a Seattle-based investment advisor and editor of the FundAdvice.com newsletter. “People have cooled their heels with this decline. The worry aspect is larger than it has been in years, and more anxiety translates into less risk-taking.”

But a simple lack of awareness among the investing public has also kept short funds on the fringe, fund managers say.

“My guess is that assets in these funds are going to grow in the first half of this year as people see the fourth-quarter numbers,” said Charles Tennes, senior portfolio manager at Rydex. Rydex Ursa, launched in 1994, is one of the oldest short funds and the largest, with $213 million in assets.

Most advisors say that although short funds can make sense for certain investors, they are inappropriate as buy-and-hold instruments.

“The funds tend to have a fairly short-term audience,” Tennes acknowledged. “If you’re feeling a little queasy you might buy them a few days ahead of a Fed announcement, for example, to hedge your bets.”

Merriman said that even among his aggressive clients, fewer than 5% ever get involved with shorting, and never with more than 10% of their portfolio.

But manager David Tice, whose Prudent Bear returned 30.5% in 2000 after losing money in its first four years, thinks short funds deserve more prominence given how “overvalued” the market remains, even after last year’s rout.

“We think we’re just in the second inning of all this,” said the Dallas-based manager. “If we get into a secular bear market, stocks will go down for a long time. It makes a lot of sense to hedge.”

Tice, whose fund also saw a fourth-quarter net outflow despite strong returns, takes a more active approach than most of his competitors, shorting pricey stocks as often as index vehicles. Current targets include telecom equipment makers and financials, two sectors he calls especially expensive.

Though attempts at market timing often foil the average investor, advisors say short funds can work better as a hedging tool in a dicey market.

Morningstar Inc. analyst Alan Papier, who covers Rydex Ursa, said the best use of that fund is to trim exposure to the S&P; 500 index and thus rebalance one’s portfolio without incurring taxable gains by selling another investment.

“If someone has been in the Vanguard 500 Index fund for five or 10 years and enjoyed the run-up but is now worried about getting slammed in a decline, that could be the perfect situation for a little hedging,” he said.

Investors should note that, as with any mutual fund, short funds are susceptible to taxable capital gains distributions.

Most short funds paid out gains last year, but in several cases the distributions were tiny. At Rydex, for instance, whose fund lineup tends to be tax-efficient, all four bear funds paid less than 1% of net asset value in distributions.

Of course, one of the disadvantages of mutual funds in general is that taxable gains are distributed to shareholders, but you don’t get the benefit of losses incurred by a fund unless you sell it.

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Josh Friedman can be reached at josh.friedman@latimes.com.

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Funds for Bears: ‘Short’ Portfolios

The bear market led to strong returns last year for most of the mutual funds dedicated to short-selling, or betting on a decline in stock prices. But in many cases, their longer-term records are dismal, and the funds have slumped this year as many stocks have rebounded. A sampling of the short funds available:* Since May 2000 inception

Sources: Morningstar Inc., Bloomberg News, fund companies