Understand the Complexity of New Funds

Principal-protection mutual funds (PPMFs)—a relatively new type of mutual fund—are gaining a large following in the investment community. These mutual funds use insurance policies to safeguard a shareholder's original investment over 5 or more years, after fees have been paid. Investors get an additional bonus if there is an upswing in the market.

Dismal market conditions and a sour economy help explain why investors are flocking to add such funds to their portfolios. The peace of mind of having a guaranteed investment that is protected against the possibility of large losses is hard to find these days. But how do PPMFs stack up against traditional investments?

PROTECTION FUND FACTS

New York

Times

According to an article in the , many financial advisors maintain that PPMFs have high fees and restrictions, including a lengthy holding period that is required to qualify for the principal guarantee. They argue that there are cheaper, more flexible ways for conservative investors to accomplish their investment goals. In addition to a diversified portfolio, Gary Schatsky, a principal at ObjectiveAdvice.com, recommends that investors consider trimming back on equities, adding to their bond portfolios, and paying off their debt.

The investment philosophy of the PPMFs runs counter to conventional practice, in which most professional investors aim to buy low and sell high. However, managers of PPMFs typically sell stocks as the stock market declines and add to their bond holdings as bonds gain in value, alleging that this balanced approach reduces shareholder risk and benefits their portfolio.

Numerous rules make the funds, which are managed by companies like Citigroup, Merrill Lynch, and ING, more restrictive and complicated than the average mutual fund. Morningstar analyst Brian Portnoy says the funds rank as some of the most complicated investments that he has ever encountered in the financial industry.

For example, you can only buy shares of PPMFs during an offering period that generally lasts about 3 months; the funds then close to new investors. The investment requires that you keep your money in the funds for a set amount of time (typically 5 to 7 years) to qualify for the guarantee. You may be charged a fee if you withdraw early.

If the shares decrease in value, you can recoup your initial investment, after deducting expenses. To take advantage of the guarantee, you have to cash out at the end of a designated period—usually on a single day. If you fail to do so, you will lose the principal protection. Many fund managers send investors and their brokers a written reminder prior to the guarantee date.

PRICE OF PROTECTION

Executives of the funds stress their positive features and say that there is no substitute for their approach. The funds'popularity is proof that they are filling a need, asserts Robert Boulware, president of ING Funds Distributor, the chief marketer of ING's 11 PPMFs. Morningstar Inc reports that close to 2 dozen of these PPMFs have been offered to investors since Aetna created the first 1 in October 1999. (ING acquired all of Aetna's funds in 2000.)

The assets of PPMFs have seen a 12-fold increase in 1 year—reaching $6.2 billion by the end of 2002. Morningstar says the 4 funds from ING that have been offered for at least 1 year have delivered 12-month returns of 2.7% to 6.7% through March 6, 2003, not including sales charges. In contrast, the S&P 500 experienced a 28.7% decline.

Times

Is the insurance worth the extra expense? Mark Wilson, a vice president of financial planning firm Tarbox Equity Inc, doesn't think so. The article notes that the insurance may cost an additional 0.30% to 0.40% of total assets in annual fees, bringing the total expense ratio to between 1.75% and 2.25% of total assets—higher than the 1.47% charged by the average stock mutual fund. The funds, typically sold by brokers, come with front-end loads (or sales charges) of approximately 5%.

Many financial planners say the insurance may not even be necessary. That's because the funds have been invested so conservatively (heavily invested in bonds) during the bear market that they resemble bond funds with high expenses. Thus, the funds also may not enjoy substantial gains if stocks rally.

Fund managers explain that PPMFs are now heavily invested in bonds because stock values have dipped in the past 3 years. Alternately, fund stock allocations will increase as the markets rebound. As for the added costs of the insurance policies, managers argue that investors never get payouts on other types of insurance (eg, homeowners), and they accurately point out that their funds have generated small positive returns recently, while most stock and bond funds are in the red.