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, it is important to understand that absolute market timing is not recommended for any investor, no matter their level of 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 for investing in both bear and bull markets.

Here's what you should know about the best mutual fund investments for a bear market. 

Best Stocks and Sectors for Rising Interest Rates

After reading How to Invest for a Bear Market, you have a few clues to watch for to begin preparing for a new bear market and you can begin looking at the types of mutual funds that can do well in the environment leading into it and the investment types that work once the bear has officially begun.

Again, when interest rates are on the rise, the economy is typically nearing a peak (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 will have the goal of capturing positive returns on the upside while preparing to protect against harder declines when the market turns down (again, think 2007 to 2008).

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 Mutual Funds: Also known as "non-cyclicals," people still need to buy their groceries and buy products, which are collectively called consumer staples, for daily living when recession begins to hit.
  • Health Care Sector Funds: Similar to the staples, consumers still need to buy their medicine and go to the doctor in both good times and bad. This is why the health sector may not get hit as hard in a bear market and recession as the broader market averages.
  • Gold Funds and ETFs: When traders and investors anticipate an economic slowdown, they tend to move into funds, such as gold funds and ETFs, that invest in real asset types that they perceive to be more reliable than investment securities, currencies and cash.

Best Bond Funds for Rising Interest Rates

Bond prices move in opposite direction as interest rates. Here are some bond types that can minimize that interest rate risk in bear market conditions:

  • Short-term Bonds: Rising interest rates make prices of bonds go down but the longer the maturity, the further prices will fall. Therefore the opposite is true: bonds of shorter maturities will do better than those with longer maturities in a rising interest rate environment because their prices. However, 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 D (PLDDX)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. Therefore intermediate-term bond funds can provide a good middle-of-the-road option for investors that wisely choose not to predict what the bond market will do in the short-term. For example, even the best fund managers thought inflation (and lower bond prices) would return in 2011, which would bring on higher interest rates and make short-term bonds more attractive. They were wrong and fund managers lost to index funds, such as Vanguard Intermediate-term Bond Index (VBIIX), which beat 99% of all other intermediate-term bond funds in 2011. Bond funds generally didn't fall in price for a full calendar year until 2013. You can also try a more diversified approach with a total bond market index Exchange Traded Fund (ETF), such as iShares Barclay's Aggregate Bond (AGG).

Consider Defensive Stock 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 recession, respectively.

Examples include healthcare sector and utilities. You might also consider sin stock funds.

Invest in Bear Market Funds (With Caution)

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%, whereas the S&P 500 dropped in value by 37% which represented a complete inverse return, or a 74% advantage over the broad market benchmarks.

You Can Always Use a 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 (and at added risk at that).

Instead, you can diversify with index funds and just let the market do what it will (because not even the pros can predict it). Here's a simple example, using all Vanguard index funds, called the "Three-Fund Lazy Portfolio:"

40% Total Stock Market Index
30% Total International Stock Index
30% Total Bond Market Index

Above all, do what works best for you. If you need further guidance, check out what to do Before You Build a Portfolio of Mutual Funds.

About Money 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.