October 10, 2002

Principal Protected Funds: Cash from Chaos

Oct. 2, 2002 -- During the late 1990s, principal protected funds languished in obscurity as stock prices soared. But in the wake of the prolonged slump in equities, the number and popularity of these funds continue to climb.

As their name suggests, principal protected funds promise nervous investors that they won't lose a dime of their capital, as long as they commit their capital for a minimum of five years. Indeed, the funds' creators structure these funds so that holders will even get some upside participation in any stock market rally, as well as full downside protection. In the current market environment, that combination has proved tempting: since last summer, five principal protected funds have raised $2.74 billion in new capital. Another eight funds now in registration should complete the fund-raising process by the end of the year, according to a study prepared by Financial Research Corporation, a Boston-based mutual fund consulting group.

"In the current market environment, the kind of capital preservation guarantee these funds offer has more value to investors than at any time in the last decade," says Kristin Adamonis of Financial Research Corp., one of the study's authors.

Until now, occasional efforts to launch this kind of fund in the United States has met only limited success. In contrast, such "guaranteed funds" have been popular in Europe since the mid-1990s as a way for investors to take their first, tentative steps into stock-marketing investing. By the late 1990s, guaranteed funds made up half of all mutual fund sales in countries like Spain and Italy.

The stock-market slump now is helping these funds make inroads in the U.S. as skittish investors try to safeguard their nest eggs. The Smith Barney Capital Preservation fund, offered by investment bank Salomon Smith Barney, raised an astonishing $900 million last spring. Others now being marketed include funds from Merrill Lynch & Co., Frank Russell and BlackRock Partners. A fourth fund from the U.S. funds division of Dutch bank ING just closed on Sept. 30.

"There is so little in the way of equity products that find ready buyers these days, that it's probably tempting for investment advisors to push them," says Burt Greenwald, a Philadelphia-based mutual funds consultant. "But they're not right for all investors."

While the concept is straightforward, the funds' structure is not. Managers purchase insurance coverage for the principal amount raised in order to provide the guarantee. To keep the insurance premiums affordable, the fund company must invest a certain portion of the capital raised in risk-free or low-risk investments, such as zero-coupon Treasury bonds. The remainder can be invested in a conservative pool of equities or a stock-market index. That allocation between stocks and bonds is constantly adjusted as interest-rate levels and stock-market volatility rise and fall. For example, the three funds launched by ING since last summer started with 40% of their portfolio in stocks, but now have only about 10% in stocks.

"There's a risk that investors will be confused about what degree of participation they actually have in the stock market," says Susan Hirshman, planning strategist for the mutual funds group at JP Morgan Fleming. "Many funds are being marketed as a way to protect your capital and still have upside (stock market) exposure."

The principal-protected fund is an unusual creation. Nominally a stock fund, it can hold up to 90% of its assets in bonds or other low-risk securities. Technically, it's an open-ended mutual fund, since investors can redeem their holdings at any time. But they can only invest during the months-long marketing period leading up to the fund's launch. That's necessary because the fund manager can't manage the guarantee feature effectively if the pool of assets fluctuates.

Those short but intense marketing periods, coupled with the proliferation in the number of principal protected funds, means the competition for investor dollars is heating up. More than ever, investment advisors need to study the nuances of each fund's structure will intensify, consultants say, as fund companies will be adding new twists to funds to make them more attractive to investors. Already, the idea of guaranteeing not just the principal but also a small, money market-like return, has been proposed. Another wrinkle is the possibility of a "do-it-yourself" principal protected fund: Some private bankers already are developing customized principal-protected products for their wealthy clientele. Savvy investment advisors may be able to replicate the strategy for their clients using zero-coupon bonds, when the strategy is appropriate.

The most suitable investors for these funds are people approaching retirement who have built up a pool of assets and whose goal is to protect that portfolio from any further erosion. A portion of those assets can benefit from a principal protected fund, "as long as it fits within the overall asset allocation of the portfolio," Hirschman says. "If the majority of someone's portfolio already is in fixed income securities, the investor and advisor need to remember that these funds (are) more like bond funds."

Other investors may want to preserve capital to meet a specific financial goal in five to seven years' time. But the funds aren't suitable for those who need flexibility, experts say, or for younger investors who can afford to take larger financial risks as they build their nest egg.

"It's most appropriate when safety is the person's top investment goal," says Greenwald

Safety comes with a hefty price tag: the funds carry loads of 3% to 5%, as well as relatively high management fees of 150 to 250 basis points, on average. And marketing a "safety first" mutual fund is a tricky task. Advisors need to be careful not to imply that that investing in stocks is now so risky that investors need a guarantee, Adamonis says. Principal protected funds shouldn't replace a diversified mix of stocks and bonds at the core of a portfolio, she argues.

Still, Bob Boulware, president of ING Funds Distributors, believes guaranteed funds make a good core holding for most investors in any market environment.

"I believe capital loss is very hard to recover," he says. The longer the market slump lasts, "the longer the memory of those losses will stay in the market," Boulware adds. "And the more people will focus not on making more but on not losing what they've got."

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