Originally created 05/12/02

Funds offer stability at a price

NEW YORK - Imagine a mutual fund that guarantees shareholders will never lose any of their initial investment.

A growing number of so-called "principal protection" funds promise just that. The funds, which are twists on the stable-value offerings found in many 401(k) and other retirement plans, use a conservative mix of fixed-income or stock investments, as well as insurance coverage in some cases, to meet their goal.

The idea is to appeal to investors who want to preserve their principal, but want higher returns than a money market or fixed-income fund might provide. At a minimum, investors get back their initial investment. In the best case scenario, when the market does well, they also take home some gains.

"The reason to buy these is that you want to participate in the stock market but you're concerned about losing your principal," said Andrew Clark, senior analyst at Lipper Research.

Not surprisingly, there are catches.

First, the funds aren't backed by the government, meaning investors have to rely on a fund company's word for protection.

Also, the promises usually apply only if you hold the fund for the long term. That's because many funds extensively use fixed-income securities, such as treasury notes or zero-coupon bonds. These types of investments guarantee return of principal plus interest, but usually take a few years to mature so funds do whatever they can to discourage investors from redemptions before then.

You also might have to reinvest your dividends to get the protections, or in other cases, the guarantee might not apply to reinvested dividends until a certain number of years has passed.

The Idex Protected Principal Stock and ING Principal Protection funds, for example, guarantee the principal only in investments held for five years.

The holding period is 10 years for protection of investments in the MainStay equity index and Scudder Target funds.

Shareholders in the Deutsche Preservation Plus Income fund, which is available to individual investors through individual retirement accounts, may face a redemption fee should they pull out when interest rates start to go higher. The exception: Investors who are making withdrawals from their IRA as permitted by the tax code, rather than just shifting funds to another investment.

And many funds open for new investment for limited periods - again because of the delicate investing balance required to make the concept work.

"Our portfolio staff is trying to keep a decent amount of equity in there. As time goes on, if money kept coming in, you'd have to buy more and more zero coupons. That would upset the mixture of bonds to equities," said Kimberly Ulrich, product manager at Scudder Funds, which is owned by Deutsche Asset Management.

Financial planners say the funds should be used sparingly and as part of a broader asset allocation plan.

"There are some attractive deals as an alternative to fixed-income investing," said Richard Krentz, a financial planner in Nyack, N.Y. "But the costs and fees can be so significant that they outweigh the benefits."

Indeed, many of the funds charge sizable upfront commissions on top of management and expense fees that frequently exceed 1.0 percent. Funds that carry a separate insurance policy tend to have higher fees. Redemption fees or back-end commissions are also possibilities.

Another factor to consider: Even if the market surges, your profit is likely to be modest. Most funds promise the principal, plus a portion of any upside should the fund do well. A Lipper analysis found that the category generally returned between 8 and 10 percent overall over the past 10 years, net of fees and expenses but before taxes - compared with a 13.2 percent return during the same period by the Vanguard 500 index fund.

Still, that might be OK, particularly amid the current difficult market conditions. Year-to-date, most of the funds in this category are flat or down 1 or 2 percent. By contrast, the Vanguard 500 has lost about 8 percent.

Industry analysts say the concept is becoming more popular as frustrated investors look for less risky alternatives.

Retirees rolling over their 401(k)s to IRAs are another potential market. Stable-value investments are offered by almost two-thirds of all defined contribution savings and profit-sharing plans, according to the Stable Value Investment Association. As the baby boomer generation heads toward retirement, it is likely many of them will be receptive to investments that look familiar.


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