Money: Place your bets for another stock market crash

If the markets go down, a bear fund goes up. Rachel Fixsen explains

Share prices are teetering near record highs. This would be enough to trigger nervousness at the best of times, but at this time of year, it is making investors distinctly edgy. Will October, which played host to the stock market crash of 1987, witness another market collapse, and will you be hit?

Not if you've invested in a bear fund - the only type of unit trust which blossoms when the stock market withers. By using sophisticated financial instruments to take bets that the market will fall, bear funds can make swift gains when share prices plummet.

"For a long time now, there have been a lot of negative factors,

like the Budget, which have had no impact on the market," says one equities analyst. "It looks like we're coming into a period when factors like interest rate rises are coming home to roost - so there are a lot more jitters."

Many experts foresee a period of weakness ahead for UK share prices, but stop short of predicting a market collapse.

John Govett Unit Management is the only fund manager to make bear funds reasonably accessible to private investors. It has seven bear funds, each covering a major world market, such as the UK bear fund, US bear fund or Japan bear fund.

"The bear funds are there to do exactly the opposite of what the index does," says Ian Taylor, marketing director at John Govett. They are authorised unit trusts, classified as futures and options funds, which hold the vast majority of their assets in cash investments. A small percentage is used to enter into futures contracts.

By selling a futures contract, a bear fund in theory promises to sell the stocks which make up the FTSE 100 index at today's prices at a set time in the future. Although in practice no shares actually change hands, if share prices fall between now and then, the fund makes a profit by buying back the contract at a lower price. The more share prices fall, the more money the bear fund makes.

So as long as the market falls, bear funds make a profit. But of course these funds have had a bad time in the last few years, with most bourses around the world surging ahead. As bear funds set out to inverse-track the market, by definition if the market rises by 5 per cent, the fund falls a similar amount.

Not surprisingly, investments in some of Govett's bear funds have more than halved in value over the last year. A pounds 1,000 investment in the Govett German bear fund would have shrunk to pounds 378.88 over the last 12 months, according to financial data provider MoneyFacts, thanks in no small part to the strength of sterling. The same investment in the UK bear fund would have fallen to pounds 738.58.

However, no one would recommend holding a bear fund for a year. These funds are only meant for short-term use. You buy into one when you think the market might fall, and sell again when the rout is over.

James Charrington, sales director at Mercury Fund Managers, which also runs bear funds, says investors might hold units for a month. "Although we have had people in these funds for up to a year," he adds. These investors might be aiming to protect themselves with a long-term hedge against a fall in US share prices, he says.

But these funds are not for the small investor. In any case, the minimum investment in any of the Mercury bear funds is beyond the average pocket at pounds 250,000. To buy into one of the Govett funds you have to hand over at least pounds 1,000.

"They are suitable for fairly sophisticated investors," says Mr Taylor. "Bear funds can be used for hedging. Rather than selling all your stock and buying it back, you can take a mirror holding in a bear fund - it's like portfolio insurance." Selling your shares and holding cash, which is the most obvious move if you take a dim view of the market's chances, means transaction fees and possibly having to pay capital gains tax.

If you're feeling bearish about the market but are not quite in the right league to use a bear fund, what can you do to protect your shares?

"The only reason why one would use a bear fund would be to hedge a pension fund or a very large portfolio," says Andrew Swallow of Ipswich-based Andrew Swallow Professional Financial Planning. He would advise nervous investors to switch assets into one of the guaranteed equity funds on offer.

Edinburgh Fund Managers offers its Safety First Fund. It invests in a managed portfolio of shares of major UK companies, including Shell and Glaxo Wellcome, and the units have a protected price, which is backed by a contract with NatWest Capital Markets.

The protected price is set at 95 per cent of the prevailing bid price of the units, and is "guaranteed" not to fall below this for the duration of the contract, which ends next January.

John Govett offers its UK Equity Safeguard Fund - a protected unit trust which has a quarterly lock-in, meaning the protected price is reset every three months. The protected price is set at 98 per cent of the fund's bid price at the beginning of each quarter.

But if your investment is for the long term, don't lose your nerve. If you hold shares as part of a pension fund, which may be a 20 or 30-year investment, what difference does the odd stock market dip make?

John Govett Unit Managers, 0171 378 7979; Edinburgh Fund Managers, 0131 313 1000; Mercury Asset Management, 0171 280 2800; Andrew Swallow Professional Financial Planning, 01473 252 156