Which Mutual Funds Are Best in a Bear Market?

What You Need to Know for Smart Investing in a Bear Market

Mutual funds in newspaper
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Before preparing your portfolio for a bear market, note that absolute market timing is not recommended for any investor, no matter their knowledge or investing skills. Not even the best professional money managers have consistent success navigating the complexities of capital markets and economic conditions. But that doesn't mean that you shouldn't learn to be prepared to invest in both bear and bull markets. 

Stocks and Sectors

When interest rates are on the rise, the economy is typically nearing a peak, as the Federal Reserve raises rates when the economy appears to be growing too quickly and thus inflation is a concern. Those who aim to time the market with sectors have the goal of capturing positive returns on the upside while preparing to protect against harder declines when the market turns down.

Traders and investors may, therefore, consider sectors that tend to perform best (fall in price the least) when the market and economy head downward.

Consumer Staples Sector

Also known as "noncyclicals." People still need to buy groceries and other products for daily living, collectively called consumer staples, when recession hits.

Health Care Sector

Similar to consumer staples, consumers need medicine and go to the doctor in both good times and bad. This is why the health care sector may not get hit as hard in a bear market as the broader market averages.

Gold and Precious Metals

When traders and investors anticipate an economic slowdown, they tend to move into funds that invest in real asset types, such as gold funds, that they perceive to be more reliable than investment securities, currencies, and cash.

Bond Funds

Bond prices move in opposite direction as interest rates, and some bond types can minimize interest rate risk in bear market conditions:

Short-term Bonds 

Rising interest rates make bond prices go down, but the longer the maturity, the further prices will fall. Therefore the opposite is true: bonds of shorter maturities do better than those with longer maturities in a rising interest rate environment because of their prices.

Keep in mind that "doing better" may still mean falling prices, although the decline is generally less severe.

A few bond funds that work well include PIMCO Low Duration (PLDRX) and Vanguard Short-Term Bond Index (VBISX).

Intermediate-term Bonds 

Although the maturities are longer with these funds, no investor really knows what interest rates and inflation will do, so intermediate-term bond funds can provide a good middle-of-the-road option for investors who wisely avoid predicting what the bond market will do in the short-term.

Even the best fund managers sometimes believe that inflation, and lower bond prices, will return along with higher interest rates, which makes short-term bonds more attractive. But sometimes they're wrong, and those fund managers lose to index funds like the Vanguard Intermediate-Term Bond Index Fund (VBIIX).

You can also try a more diversified approach with a total bond market index Exchange Traded Fund (ETF), such as iShares Core U.S. Aggregate Bond (AGG).

Inflation-Protected Bonds 

Also known as Treasury Inflation-Protected Securities (TIPS), these bond funds can do well just before and during inflationary environments, which often coincide with rising interest rates and growing economies. A few standouts for TIPS funds include Vanguard Inflation-Protected Securities Fund (VIPSX) and PIMCO Real Return (PRAIX).

Defensive Sectors

Sector funds focus on a specific industry, social objective, or industrial sector such as health care, real estate, or technology. Their investment objective is to provide concentrated exposure to specific industry groups, called sectors.

Defensive sector funds invest in sectors that may perform well in relation to other industries during a period of market or economic weakness, such as a bear market or a recession, respectively. Examples include the health care sector and utilities. Another sector that tends to perform steadily in weak market conditions is sin stocks.

Bear Market Funds

Bear market funds are not for everyone. They are mutual fund portfolios built and designed to make money during a bear market, hence the name. To do this, bear market funds invest in short positions and derivatives, thus their returns generally move in the opposite direction of the benchmark index.

For example during the bear market of 2008, some bear market funds had returns of more than 37 percent, whereas the S&P 500 dropped in value by 37 percent, which represented a complete inverse return, or a 74 percent advantage over the broad market benchmarks. That said, their returns are often highly volatile, and like with any securities purchase, investors should exercise caution and do their research.

Lazy Portfolio Strategy

For most investors, it can be smart to simply stay out of the market timing and nuanced strategies of attempting to squeeze out every possible bit of return.

Instead, you can diversify with index funds and let the market do what it will, knowing that not even the pros can predict it with any reliable degree of accuracy. One simple example, using all Vanguard index funds, called the "Three-Fund Lazy Portfolio," which has shown positive results over time and through many market conditions.

40% Total Stock Market Index (VTSMX)
30% Total International Stock Index (VGTSX)
30% Total Bond Market Index (VBMFX)

Above all, do what works best for you.

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.