Inverse funds: Risky bet isn't for long-term investors

(MONEY Magazine) -- I've worked at several companies with 401(k) plans, but none of them has offered an "inverse fund," or a fund that moves in the opposite direction of the market. I think this would be a nice diversification option to have when the market is shaky. Is there a reason this option hasn't been available in any of my 401(k)s? -- Paul, New Hope, Minn.

I can think of a few reasons your employers might not have thrown an inverse -- a.k.a. "bear market" -- fund into your 401(k)'s lineup.

Maybe they felt that many 401(k) investors, especially beginners, wouldn't understand how the funds work. Or perhaps they were worried about being sued by investors who jumped into these funds expecting a market decline, only to lose money because the market rose instead.

Or, and I may be overly optimistic here, maybe the people who oversaw your 401(k) plans realized that inverse funds really don't make a great addition to a portfolio designed to build a sizeable nest egg over the long term.

As you've no doubt guessed, I'm no advocate of making inverse or bear market funds part of a portfolio, whether that portfolio is held in a 401(k), IRA, taxable account or anywhere else. My objection to these funds is simple: they are designed for speculation, not long-term investing.

True, you can score big if you buy one just before the market takes a dive. For example, if you'd invested in the Rydex Inverse S&P 500 Strategy fund (RYURX) at the beginning of 2008, you'd have earned almost 41% in a year the S&P 500 lost 37%. Nice score.

Would you have done that? Or would you have been more likely to buy into such a fund much later, after you became convinced the S&P 500's descent was for real. If you'd held off until the beginning of October, 2008 -- when it became clear the market had fallen off a cliff -- you would have lost 10% in the fund over the next 12 months.

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In short, these funds require powers of clairvoyance and timing that investors just don't possess. As for your suggestion that an inverse fund would be a good diversification option, that's not the case.

Granted, it's possible that adding a small dose of an inverse fund to a conventional stock-and-bond combo and periodically rebalancing can reduce the volatility of your portfolio overall. But there's a huge downside: since markets tend to rise over long periods, these funds by their nature are likely to lose money over the long term.

Rydex Inverse S&P 500 Strategy, for example, has posted a negative 6% annualized return over the past 10 years, which means that $10,000 invested 10 years ago is worth less than $5,400 today.

The result is that any benefit you get from lower volatility is likely to be dwarfed by the fact that an inverse fund is significantly stunting the eventual size of your nest egg.

Money 70: Funds to count on

There's another complication that makes inverse funds a dicey choice. Since these funds are designed to track an index like the S&P 500 on a daily basis, their performance is far less predictable over periods longer than a day.

The result is that investors in inverse funds could lose far more than they expected if the market rises rather than falls, especially if they own the "leveraged" version of these funds.

To sum up, I consider inverse funds another example of how investment firms can take a perfectly good concept -- in this case, index funds and ETFs -- and pollute it by touting dangerous variations that cater to our worst instincts.

I suggest you avoid inverse funds altogether.

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