As mutual fund companies struggle to retain investors in a market rife with fear, one of the pitches they're using is "safety." That's one reason, at least, that principal protection mutual funds seem to be growing in popularity.
These funds, on their face at least, appear to be as secure as you can get-guaranteeing investors will not lose their initial investments as long as certain conditions are met. Among those conditions are that investors leave their money untouched for five or 10 years, depending on the fund, and accept a higher-than-average expense ratio.
Investors also can't expect to make a killing. These funds lie somewhere between money markets and bond funds when it comes to volatility, and generally are marketed as alternatives to both. As far as performance, analysts say they fall between a bond fund and an S&P index fund.
It's also important to note that they are distinct from, but hybrids of, the stable value mutual funds that are commonly found in IRAs, 401(k)s and other managed retirement accounts. "In many cases, it's investors who may have moved to cash if they hadn't had a safer option," says Bob Boulware, president of ING Funds Distributors. "We think they are targeted to the serious investors-any person who has accumulated an important amount of money and is serious about preservation of capital."
ING introduced its first principal protection fund, the ING Index Plus Protection Fund, in 1999. The family has since grown to eight funds and an offering period is underway for a ninth.
Other companies that offer similar funds are Salomon Smith Barney and Scudder Funds, whose Target family of principal protection funds was introduced in 1990 and now includes seven funds. Indications are that the number of funds is growing. BlackRock Financial, for example, has registered a principal protection fund, and there is talk of others in the works.
Analysts, meanwhile, say it's too early to tell if there's a real trend of investors gravitating toward these funds or if it's more a matter of fund companies trying to stir up interest. If they do grow in popularity, however, they say it wouldn't be surprising. "I think there are a lot of investors who are panicking right now, and for good reason," says Morningstar fund analyst Brian Portnoy. "The principal protection idea comes along at a time when the investors want exactly what these funds are selling."
But analysts stress that, like all funds, principal protection funds do contain fine print that deserve the attention of advisors and their clients. As secure as the set-up sounds, there are drawbacks to investing in these funds that could make them unsuitable for some portfolios. Among the considerations with these funds are limited upside, long horizons and high expense ratios-as high as 2% in some cases, Portnoy says.
Principal protection funds typically utilize a mix of fixed-income and large-cap equity investments, with the principal guarantees supported by either insurance agreements or zero-coupon bonds. As market volatility increases, however, funds usually significantly overweight in fixed-income investments. That limits downside exposure, but also severely curtails an investor's ability to benefit from a turnaround, analysts point out. "If the markets pick up at all in the next few years, you are going to miss out on the upside," Portnoy says.
The funds can also include safety triggers that could drastically change the fund's characteristics. ING's products, for example, include a provision that if the equity portion of the fund drops 30% or more in a single day, a "complete and irreversible" reallocation to fixed income may occur.
Principal protection funds typically have a limited subscription period, then undergo a "guarantee period" of five or 10 years during which new investors are locked out. The guarantee on the initial investment, however, is only valid if investors keep their money invested throughout the entire term of the guarantee period. During the holding period, investors are also required to reinvest all dividends and capital gains.
If investors sell any shares before the maturity of the guarantee period, they may not only lose the guarantee but also be subject to redemption fees. Scudder's family of principal protection funds does allow some flexibility by permitting investors to sell shares while retaining guarantees on any remaining ones, says Kimberly Ulrich, Scudder Funds product manager. "If you need to take something out, you can, and the remaining portion is still guaranteed," she says.
Scudder's Target funds, which have a 10-year holding period, also do not charge a redemption fee on withdrawals. But this is somewhat offset by the fact the fund is sold only in A-share form, subjecting investors to an upfront sales fee.
ING, whose funds have a five-year holding period, does charge redemption fees depending on whether investors hold A, B or C shares. "You have to be comfortable with a lockout period," says Andrew Clark, senior analyst at Lipper Research.
Another key point is that investors are usually guaranteed their initial investment minus expenses-and the expenses can add up. For example, ING's expense ratios range from 1.75% for A shares and 2.50% for B and C shares. A full 33 basis points of the ratio is just to pay for the insurance that covers the guarantees, Boulware says. Scudder, which utilizes a mix of zero-coupon bonds and common stocks to make the guarantee work, has an expense ratio of 0.95%, says Ulrich.
Funds also have different ways of transitioning the funds once the holding period is over. ING, for example, converts the funds into large-cap S&P 500 Index funds. Scudder recycles the funds by taking on new investors and launching another 10-year holding period.
Once past the fine print, analysts say the funds do achieve their stated purpose: providing investors with a solid and comfortable ground floor when the market heads south. That has been demonstrated this year, with most principal protection funds only several points above or below even.
"The guarantee is the guarantee. You will get your principal back, less expenses," Portnoy says. "The most important thing investors have to do is read the fine print, because if they think fund companies are giving them a free lunch, they have another thing coming. Safety comes at a cost."
Clark of Lipper considers them more something to address investor nervousness than a diversification tool. "When these funds first came out, they were targeted at those who were putting all their money into savings accounts" and were looking for a way into the stock market without losing money, he says. "To me, that is still their primary audience."
Yet it remains to be seen if the funds will generate significant interest in the advisor community, given the fees and stringent holding periods. "With the ones we looked at, the guarantees are more expensive than they're worth," says Harold Evensky, principal of Evensky, Brown & Katz in Coral Gables, Fla.
Evensky says he prefers to build the same downside protections on his own with the use of zero-coupon bonds in combination with a balanced portfolio. "I don't think any fee-based advisors will be interested in these," he says. "My best guess is it's going to be a commission-driven business."
Then there are the stable value funds, which some advisors prefer as an alternative to the type of safety cushion provided by principal protection funds. Robert Zimberg of Financial Mountain in Boulder, Colo., for example, recently started using Deutsche Asset Management's Preservation Plus Income Fund for client IRA accounts.
"I'm using it as a money market alternative," he says. "This is for clients who are wanting go get some more return and take a little less risk."
The fund, introduced in 1998, consists of an intermediate duration bond portfolio supported by a wrapper agreements with various banks that ensures net asset value will remain at $10 per share. "What you end up with is an investment that delivers the income of an intermediate duration bond fund" with lower volatility, says John Axtell, managing director and head of Deutsche's Stable Value Management Group. (Deutsche also owns Scudder Funds).
One thing investors need to be aware of, analysts say, is that a 2% redemption fee kicks in if there is a dramatic rise in interest rates. Axtell says the trigger has yet to be activated.
Fees are also relatively high with this fund, which has an expense ratio of 1.50%, although Axtell notes a voluntary waiver is currently in force that has lowered the ratio to 1%. The fund, which has brought investors 3% a year to date, has seen its assets grow from $25 million at the end of 2001 to $442 million currently, he says.
The jump in assets contrasts to the first few years of the fund's existence, when it relied on a core of "loyal investors" who came in early and stuck with the strategy, Axtell says. "To be honest, the first few years no one wanted to talk about fixed income," Axtell says.