By John Wasik
CHICAGO Feb 11 (Reuters) - There is such a thing as being too cautious - betting on fear to such an extent that it derails your portfolio.
But if you are pessimistic about economic prospects in 2013 and thinking of investing in some bearish funds, this strategy could be hazardous to your wealth. You should consider yourself forewarned by what happened in 2012 with funds that embraced an aggressive bearish strategy: They were mauled.
Take the iPath S&P 500 VIX ST Futures A ETN, which was one the most hotly traded funds in 2012, according the Top 20 list of average daily trading volume compiled by trade newspaper Investment News. This specialized fund is an exchange-traded note - a publicly traded instrument issued by a bank - which gains when volatility-linked futures contracts soar in price. A short-term measure of investor anxiety, these funds make sense when the market is topsy-turvy, but not in a bull rally. Last year, the iPath note lost 78 percent.
Another big, bearish loser, the Direxion Daily Small Cap Bear 3X Shares fund, lost 49 percent of its value last year. The fund, which gains three times what a small-cap index does during a decline, was 10th on the top-volume ETF list.
Overall, a pessimistic view was represented by eight bearish, non-precious metals funds in the high-volume, hot-money list. All but one of them lost - from 12 percent for the ProShares Ultrashort 20+ Year Treasury ETF, which makes money if prices on long-maturity Treasury bonds fall, to the ProShares Ultra Vix Short-Term Futures fund, which lost a heart-stopping 97 percent last year and offers twice the return of an S&P 500 volatility index.
The one that held up was the iShares Silver Trust, which gained 9 percent. It is not a pure bear strategy fund, but rather one investors sometimes use to bet against the stock market.
All this goes to show that hot money is not necessarily smart money. The S&P 500 rose 16 percent in 2012, with dividends reinvested, and those who wagered on a continuing U.S. and global recovery were right, and may be well positioned for future gains.
If you had put your money on bullish funds last year, you could have done well with something such as the SPDR S&P 500 ETF , which tracks the largest 500 U.S. companies. A worthy core holding for any long-term portfolio, it gained nearly 16 percent last year.
Even if you use the most conservative economic outlook for 2013, making large bets on bear funds doesn't make sense.
According to the Conference Board, an independent business research organization, growth in advanced economies is expected to see a 1.3 percent uptick. While that's hardly worth a parade, it factors in a small recovery in the euro zone and almost 2 percent gross domestic product growth in the United States.
Slow-but-steady growth likely translates into less stock-market volatility, which means you should stay away from funds that are indexed to market skittishness. This doesn't mean that volatility will go away, it will just be harder to make money on short-term investor anxiety. Remember, even meager growth and stability will calm the markets somewhat.
The same holds true for inverse funds, which mostly feed on short-term volatility. Such sentiment is hard to time and doesn't materialize in a significant way when a rising tide lifts all ships.
Metals funds, which indirectly track bearishness and often run in the opposite direction of stock prices, may be a different matter. If growing economic activity sparks a rise in inflation, they can benefit. But keep in mind that, over the last few years, there has been little actual increase in the overall cost of living and these funds have largely reflected the anticipation of inflation.
If you still feel nervous - and you should never place too much faith in forecasts - there's no harm in having 10 percent or less of your portfolio in bearish or metals funds. Just be careful not to time trades or over concentrate in them. Hedging is not to be confused with speculating on a scenario that's overwrought and overblown.