Another Contender For Safe Money Emerges

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Principal protection mutual funds are emerging as serious contenders for todays “safe money” dollars.

Such funds typically guarantee a return of original principal–sometimes minus certain charges–to the investor, even if the funds value plunges to zero. To get the guarantee, the investor needs to leave the money in the fund for a set period (typically five or 10 years).

Also called principal return funds, capital preservation funds, return of principal funds, and other appellations, these mutual funds might seem like new kids on the block to some investment advisors. But they are not new. Scudder Investments, New York City, brought out its first such fund in 1992; Salomon Smith Barney debuted one in the early 1990s, too; and Aetna Financial Services (now a part of ING) put one inside a variable annuity in 1996.

Despite these early entries, principal protection funds did not turn many heads in the financial rep community during the 1990s. Growth, tech and other hot funds were all the rage then. But today, with the stock market downturn over two years old, principal protection funds are starting to look more interesting. At some fund companies, theyre drawing significant sums.

For example, at ING Investments, Des Moines, Iowa, the principal protection fund “has been the best selling fund in our VAs since we started offering it in July 2001,” says William Lowe, senior vice president-wholesale distribution for INGs U.S. operations, Des Moines. The company also offers its principal protection fund as a retail fund.

The latest ING offering–the ING Principal Protection Fund IV–has already brought in $516 million, following its July 1, 2002 debut, he points out. (This offering closes on Sept. 30, 2002.) Furthermore, INGs previous Principal Protection Funds, each also having a three-month offering period, “have attracted nearly $2 billion in assets,” according to the company.

IDEX Mutual Funds, a St. Petersburg, Fla., member of Aegon/Transamerica, says its first such fund–the IDEX Principal Protected Stock Fund–drew $70 million during its three-month offering period, which closed June 27, 2002. (When the offering period closes, IDEX transfers the assets into the fund.)

So pleased is IDEX with the results that it is preparing a second offering.

Scudder, a member of Deutsche Asset Management and a veteran marketer in this field, says its current principal protection fund–the Target 2012 Fund–had assets of $73 million, as of Aug. 30, 2002. This is a “relatively high amount for a relatively new fund,” says Peter Jacobs, director-product management, noting that the company has six other funds in different stages of maturity.

(Note: This fund originally debuted, in February 1992, as the Scudder Retirement Fund Series III. After its original offering period, it closed to new purchases. Then, when it “matured” at the end of its 10-year period, it “reopened” on Feb. 15, 2002, under its new Target 2012 name, for another 10-year period.)

What is the appeal? “The funds make people feel good,” says Scudders Jacobs. Many investors are uncomfortable now, due to the volatile stock market, he explains. “This assures theyll get their money back,” if the market doesnt pick up during the investment period.

“Money goes somewhere,” explains Lowe of ING. “The lower fixed interest rates go, the more people will want to seek alternatives, and equities are often the alternative of choice. But when people are scared of equities, where are they going to go?” Increasingly, he answers, theyre going into principal protection funds.

Jacobs agrees. Protection is what reps are selling today, he says. “Theyre selling guarantees.”

He concedes that no Scudder investor has ever needed the guarantee. For example, if someone deposited $10,000 into Scudders principal protection fund in 1992, he says, that person would have had an account value of $20,316 by June 2002.

Even so, Jacobs continues, having that guarantee was very important to investors who went into that fund. In 1992, he explains, “another recession was on, and investors then wanted principal protection the same way many do today.”

“This is for the buyer who wants some equity exposure but who is afraid of volatile markets,” adds Lowe of ING. “Right now, thats the large majority of investors.”

And, when sold inside a VA, the fund serves as an alternative to low fixed annuity rates, Lowe says, noting that FA crediting rates have plummeted in recent months.

During a period when the stock market is rocking and rolling, “these funds will not compete with returns on traditional stock funds,” Lowe agrees. “But they do provide principal guarantees, and that is the solution that many investors want right now.”

Put simply, he says, “this is a cash guarantee–a guarantee that you will get your money back if you stay in the fund for the whole period.”

Its “upside potential of the market with downside protection,” says IDEX.

How do the funds support the guarantee? Each uses its own strategy, but the typical approach, at the fund management level, is to combine zero coupon U.S. Treasury bonds with limited equity stock exposure. (Generally, the fund manager purchases the zeros at a discount; their value increases over time and matures when the guarantee matures.) Some funds also use an insurance wrapper.

The marketing materials for the IDEX Principal Protected Stock Fund, say that AEGON/Transamerica Fund Advisers Inc. is the guarantor for the funds five-year guarantee.

Note: The IDEX guarantee is for return of principal, less certain loads and expenses, if the money stays in the fund for a five-year period. The fund materials say the product invests “primarily in the 500 stocks included in the S&P 500 Index,” and uses a “risk management strategy” to limit the exposure to risk.

In INGs product, which also offers a five-year guarantee, the “ultimate guarantor” for the principal protection fund in the VA product is ING, says Lowe. However, he adds, the fund is structured in such a way that “the manager will manage the portfolio to cover the guarantee.”

A product announcement on the ING Principal Protection IV debut says the “period of guarantee of principal–less sales charges and certain fund expenses–is backed by MGIA Insurance Corp.” MGIA is an AAA-rated monoline insurer, it says.

Scudders fund, which offers a 10-year guarantee, says “this assurance is provided by the par value of the U.S. government zero-coupon bonds as well as from the investment manager.” The fund advisor is Deutsche Asset Management, says Jacobs.

Zeros “can be more volatile than interest bearing bonds,” Scudder allows. So, it says, “the fund invests in zero-coupon bonds with maturity dates of 10 years, which historically are much less volatile than longer-term bonds.”

In assessing these funds, financial advisors need to examine the features, say experts. Ask, for example:

What are the fees? This varies. In INGs VA product, “there is an extra 50 basis point charge in the fund to account for the guarantee,” says Lowe, noting that the total fund charge is 150 bps. At Scudder, “our total expenses for these funds range between 97 bps and 106 bps,” says Jacobs. The 2012 offering has a fund expense of 100 bps.

What are the share classes? IDEXs first fund offered both A and B shares. Scudders 2012 fund offers A shares. INGs fund offers A, B, and C shares.

What is the contingent deferred surrender charge (if there is one)? On the Class B shares, these typically decline over the guarantee period.

Can the investor redeem shares before the end of the surrender period? Typically, this is allowed. But, as IDEX puts it, shareholders who do this may lose money. This exposure to loss reflects the fact that shares redeemed early come out of the fund at current market prices, which may be lower (or higher) than the initial share prices, say fund executives. This money may also be subject to a contingent deferred sales charge, and/or may trigger a taxable event.

What happens when the fund matures? At ING, investors can keep the balance in the fund, exchange assets into the same share classes of other ING funds, or receive the balance in cash. At Scudder, the practice in the past has been to allow exchanges to other Scudder funds, redemption of the account, or reinvestment of the value into a new 10-year guarantee program. (Note: exchanges and redemptions may be subject to taxes or CDSC charges).

Can the investor buy additional shares during the guarantee period? If the fund is still open, yes. Otherwise, no.

What if the stock market heats up while the money is still in the guarantee period? The investor can always pull out of the fund, but some funds offer other options, too. For example, IDEX allows investors to elect to “step up” their account value on July 1 of each year for the five-year guarantee period, to “lock in” market gains.

Do investors pay taxes on the fund during the guarantee period? If the fund is in a non-qualified retail account, yes, yearly 1099s go out, as with any mutual fund. If the fund is inside a VA or qualified plan, taxes are deferred, as with any VA or qualified plan.

“In 1999, everyone would have yawned at a fund like this,” says Lowe. “But today, investor confidence has been shattered, so this is the way to go.”

Only a handful of these funds exist, but word is, other fund companies are planning to make offerings, too.


Reproduced from National Underwriter Life & Health/Financial Services Edition, September 30, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.