All the major U.S. indexes are already in correction mode. Whether they will enter the bear market largely depends on the state of the Chinese economy, which continues to be discouraging. The continuous drop in oil prices is also threatening to further drag the broader markets down. These factors have not only resulted in a bloodbath in the U.S. stock market this year but have also dented investor sentiment for some time now.

In such a scenario, where the stock market is not very reliable, it will be prudent to buy funds that apply market neutral equity strategies. These funds have little or no correlation with broader market downturns and volatility.

The Possibility of a Bear Market

A persistently downward trend followed by a price decline of 20% or more is generally accepted as a bear market. By this definition, we are heading toward a bear market ever since last year. Though the S&P 500 and the Dow haven’t entered into a bear market yet, they snapped a multi-year winning streak to end in negative territory in 2015. Moreover, in 2016, the S&P 500 and the Dow have plunged a respective 7.4% and 7.8% year to date.

Considering their drop from the highs, they are nearing a bear market. The S&P 500 is now 12.5% off its May 21 record high of 2,130.82 and would be in a bear market if it touches 1,706. The Dow has dropped around 13% from its May highs. It needs to fall to 14,681 to be in the bear zone.

However, almost 50% of the S&P 500 companies have fallen more than 20% from their 52-week highs this month. Additionally, companies having small market capitalization are already in a bear market territory. Small caps have fallen to a fresh two and a half year low during the second week of January.

Chinese Economy and Oil’s Decline Signal U.S. Slowdown

The stock market crash in China is the biggest warning sign of a bear market this year. Chinese stocks tanked about 40% from their June peaks, frightening investors worldwide. Chinese banks aren’t accepting stocks as warranty for loans, while bank loans in China declined drastically indicating investors’ lack of faith in Chinese markets.

China plunged into a bear market territory, while other nations throughout the world including United Kingdom, France, Germany and Japan also entered a bear market. This global meltdown is expected to have a significant negative impact on the U.S. economy. U.S. exporters aren’t the only ones to be affected; domestic commodity producers will feel the pain because of weak global demand and low commodity prices.

Similarly, the slump in global oil prices mostly due to lower demand in an already oversupplied market is also affecting the broader markets. BlackRock Chairman and CEO Larry Fink had said that oil prices could test the $25 per barrel mark and the stock market is anticipated to fall a further 10%, which will eventually ensure that the U.S. markets have entered the bear phase.

U.S. Economy Looks Unimpressive 

Except for an upbeat labor market, the U.S. economy is plagued by a slew of weak economic data. Retail sales were down 0.1% in December indicating a fall in consumer spending levels. Meanwhile, a drop in industrial production by 0.4% last month showed weakness in utilities, mining and motor vehicle production sectors.

The International Monetary Fund had also trimmed its 2016 forecast for U.S. economic growth to 2.6% from an earlier forecast of 2.8%. Investors have pulled out a whopping $24 billion from U.S. equity funds during the first three weeks of January due to fears of a slowdown, according to Bank of America Corporation (BAC).

5 Funds to Brave a Bear Market 

Let’s assume that the U.S. economy is moving toward a bear market. In this scenario, the focus is not about return on capital but it’s about return of capital.

Market neutral funds should be bought in this situation as it provides protection from downside risks in any market. Market neutral funds have low levels of correlation not only with the equity markets but also with other broad asset classes including commodities and fixed income instruments.

Moreover, market neutral funds offer lower levels of volatility than the broader equity markets. Additionally, these funds have beta around zero. This means that their performance isn’t affected much by a sharp sell-off in equity markets.

Meanwhile, the Fed had increased interest rates for the first time in nearly a decade last month. In a rising interest rate environment, market neutral funds provide higher returns. These funds sell stocks and receive proceeds which earn a rate of return tied to the federal fund rate. When short-term interest rates increase, so does the interest rate earned by market neutral funds.

Separately, a long/short fund also comes into play as it utilizes leverage, derivatives and short positions in order to maximize total returns, irrespective of market conditions.

We have shortlisted the top five funds that deploy Market Neutral and Long/Short strategies. They have impressive 3-year and 5-year annualized returns and carry a Zacks Mutual Fund Rank #1 (Strong Buy). These funds also possess a relatively low expense ratio, carry low beta and the minimum initial investment is within $5000.

Calamos Market Neutral Income A (CVSIX - MF report) seeks current income. CVSIX invests in convertible securities and employs short selling to hedge against market risk. CVSIX’s 3-year and 5-year annualized returns are 1.6% and 2.7%, respectively. CVSIX’s 1-year and 3-year beta scores are -0.4 and 0.05, respectively. Annual expense ratio of 1.11% is lower than the category average of 1.71%.

Gateway A (GATEX - MF report) seeks high returns associated with equity market investments, while exposing investors to significantly less risk than other equity investments. GATEX’s 3-year and 5-year annualized returns are 2.5% and 3.1%, respectively. GATEX’s 1-year and 3-year beta scores are 0.38 and 0.35, respectively. Annual expense ratio of 0.94% is lower than the category average of 1.82%.

Turner Titan II Investor (TSPCX - MF report) seeks long-term growth of capital. TSPCX invests in equity securities of large-cap companies using a long/short strategy. TSPCX’s 3-year and 5-year annualized returns are 1.9% and 0.9%, respectively. TSPCX’s 1-year and 3-year beta scores are zero and 0.2, respectively. Annual expense ratio of 1.67% is lower than the category average of 1.71%.

Glenmede Long/Short (GTAPX - MF report) seeks absolute return. GTAPX invests a large portion of its assets in long and short positions with respect to equity securities. GTAPX’s 3-year and 5-year annualized returns are 4.5% and 4.8%, respectively. GTAPX’s 1-year and 3-year beta scores are 0.33 and 0.36, respectively. Annual expense ratio of 1.16% is lower than the category average of 1.82%.

Diamond Hill Long-Short A (DIAMX - MF report) seeks long-term capital appreciation. DIAMX invests its assets in U.S. equity securities that are undervalued and sells short equity securities that are overvalued. DIAMX’s 3-year and 5-year annualized returns are 4.9% and 5.9%, respectively. DIAMX’s 1-year and 3-year beta scores are 0.75 and 0.7, respectively. Annual expense ratio of 1.4% is lower than the category average of 1.82%.