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As I continue from Part 1, let me explain further why mutual funds can get killed during bear markets. A down market is the best way to lower the cost basis of the fund’s securities positions.

But during a bear market, funds have very little cash because investors aren’t buying funds. As well, remember that fund managers can’t go to cash so they’re not able to lower the cost basis of their most undervalued positions.

But they have another, often bigger problem to contend with; net redemptions. Fund managers also have to worry about redeeming shares of the fund for investors who want out. And if they don’t estimate this amount accurately, they might have to sell when stocks reach multi-year lows (which is typically the worst time to sell). And with fewer investors buying mutual funds during bearish periods, fund managers have less new cash to lower the cost basis.

Fund managers should be buying during bear markets but they just don’t have the cash. Remember, lowering the cost basis of the fund’s securities positions is their single best asset management tool.

Even when they do have sufficient cash, they are betting that their favored positions won’t go to 0; you know, like WorldCom, Enron, Washington Mutual, Lehman Brothers, Bear Stearns, and soon to be General Motors, Ford, Fannie Freddie, etc.

Therefore, unless a fund has been structured in a way that allows the fund manager to invest in special asset classes that provide hedging strategies, the fund will get slammed hard during large market corrections, often more so than the market itself.

You might recall that during the height of the dotcom bubble, there were more mutual funds than individual securities, at nearly 13,000. By 2003, there were just over 7000 mutual funds remaining. So much for the safety provided by diversification.

The fact is that the ability to avoid or minimize market risk is the single best asset management skill to have. Mutual funds aren’t able to do this. And Wall Street won’t tell you this because they are in bed with the fund industry.

While there are a few of these so-called “bear market” funds, when you examine the returns, they are far from impressive. One such fund is Federated’s Prudent Bear Fund (BEARX) recently purchased from David Tice; a CNBC media ham. If you look at the returns over the most favorable period for this fund (from 2000 to current), after adjusting for all costs, your returns would have been similar to that of a Certificate of Deposit (CD). If you look at the performance prior to the current bear market (i.e. before 2008) the results would be much worse.

Finally, if you look at the cost-adjusted performance since inception, you’d be lucky if you netted 1% after all fees and taxes. To have a fund focused on the short side over the two biggest bear markets in history with these returns is beyond lousy.

So who do you think is REALLY making money in mutual funds? Over a long period, the real money is being made by the fund in terms of the various fees. Data shows that the average mutual fund, if invested for around 50 years, will take most of your gains in the form of fees, or around 79% of the gross returns. Hopefully by now you realize why. It’s those dang bear markets that kill fund investors the most.

Either way, during a bull and bear markets, mutual funds will snag you for an average of 3.5% annually for the average no-load fund, after you account for all expenses (some of which are not adequately disclosed). And most important, they have no means to manage risk, specifically the most deadly risk of all; market risk.

In reality, mutual funds are only appropriate for people who have very little money, as a way for them to participate in the stock market. After all, the minimums to open these accounts are usually $500-$3000. What does that say about the market they are trying to reach? Now you know why so many fund managers and investment advisers love going on CNBC; because sheep aren’t particularly wealthy.

One must question whether such individuals should even be in the stock market. Perhaps they are better off in CDs. The problem is that most investors got spoiled by the bull market of the 1990s, unaware that most funds were underperforming when adjusted for fees and investment risk.

Why does no one else bother to tell you this? Mainly because very few investment professionals understand how mutual funds really work. Even if they did, they aren’t going to bite the hand that feeds them. In fact, people like to make money the easy way; by riding the wave – writing books and newsletters on mutual funds because they know there will be a huge audience.

The real experts who are honest will disclose the realities as I have here. So why have you never seen any of these “experts” come forward with the truth as I have?

Come back in the future if you want to find out the biggest mutual fund scam in the world. You are going to be shocked whose involved.

This article was modified from a portion of the appendix of my latest book, “The Wall Street Investment Bible.” That’s right, the appendix, not the body.

Yet, for many, I would estimate the value of this article is almost priceless now you understand the limitations of mutual funds (and managed money).

If you want to detach your dependence on others for investment insights, this book is the single-best resource available today.

Click here to read excerpts.

Why Mutual Funds are the WORST Investments During Bear Markets (Part 2)