Fund Insurance: Is It Really Necessary?
You’re familiar with auto, home and life insurance. Now get ready for insurance on stock mutual funds.
Lord Abbett & Co. of New York recently unveiled an equity portfolio that guards against losses. Original shareholders are guaranteed to get back their initial investment on the fund’s 10th anniversary in the year 2000, regardless of where the stock market stands then.
Of course, that initial investment won’t seem like much after a decade of inflation, but it’s better than nothing. And investors would also enjoy unlimited upside potential if the fund does well.
Lord Abbett appears to have broken ground as the first mutual fund company to contract with an independent insurer to guarantee a minimum share price at a future time.
But why is insurance necessary? Quite simply, for public relations. Many small investors, still jinxed by the 1987 market crash and other nerve-wracking bumps along the way, have largely avoided equity securities, and such insurance might make them feel better. “People are scared of stocks,” says Dan Carper, national sales and marketing manager for Lord Abbett.
Of the more than $1 trillion invested in mutual funds, only about 24% is in stock funds. Bond portfolios account for 37% and money market funds, 38%.
The Lord Abbett Equity Fund will invest primarily in the common stock of large companies with sound finances and good growth prospects. The fund’s original price of $10 a share will be guaranteed by Financial Security Assurance, an insurance unit of US West, the regional telephone company. Reflecting its claims-paying ability, FSA carries a top triple-A rating.
In return for the coverage, the fund--and thus, investors--will pay the equivalent of 5 cents a year for each outstanding insured share. For two key reasons, there’s a good chance FSA won’t have to pay out a single penny when the fund matures on May 31, 2000.
First, a provision of the guarantee requires Lord Abbett shareholders to reinvest their dividends and capital-gains distributions in the fund. This type of compounding can dramatically boost the value of an investment over time.
Second, and perhaps more important, the stock market has a strong long-term tendency to rise. Ibbotson Associates of Chicago calculated equity returns during every 10-year span from 1926 to the present. The company found that the stocks in the Standard & Poor’s 500 and its predecessor index lost money just twice (in 1929-1938 and 1930-1939) out of 55 such 10-year periods.
“The fund probably doesn’t need insurance,” Carper concedes. “But the public doesn’t believe in stocks. Perhaps this product will break the emotional cycle investors go through.”
Most individuals will require some equity investments if they hope to beat inflation over time, argues Richard M. Reilly, president of Quest for Value Advisors, a mutual fund group based in New York. “There’s a big gap between the actual assets that people have and their retirement expectations,” he says. “I strongly believe that people generally need some equity component to meet their goals.”
William Berger, president of Berger Associates, a Denver company that runs two equity funds, agrees. “The best defense is a good offense,” he says on the topic of stocks versus inflation. And he reminds jittery investors that even traumatic short-term declines will tend to appear less severe over time. “The ’87 market crash seemed awful back then, but now it looks like just another blip on the chart.”
Reilly expects to see more mutual fund companies offer various types of guaranteed portfolios to lure a nervous public back into the stock market. He calls the Lord Abbett fund an “equity investment with training wheels.”
Actually, although Lord Abbett appears to have hit upon a unique wrinkle, certain other financial companies already offer stock investments backed by a guarantee. However, these products use bonds, not insurance, to safeguard payment in the future. In addition, they’ve been packaged not as mutual funds but as “unit investment trusts,” which are fixed, unmanaged portfolios that typically mature on a specific date.
Since 1985, for example, Paine Webber has put together 11 Pathfinders Trusts, nine of which have a 50-50 mix of common stocks and zero-coupon Treasury bonds.
Zero coupons don’t pay regular interest the way other bonds do. Instead, they’re sold at a deep discount and increase to face value upon maturity. So, by purchasing zero-coupon Treasuries when they’re selling for 50% of their face value--and by placing 50% of a trust’s assets into zeros--Paine Webber can guarantee to return an investor’s original principal, even if the stock market crumbles.
A worst-case scenario assumes that all of the stocks held in the trust would somehow become worthless by the maturity date. Most likely, they would actually increase in value by that time. But by offering the guarantee, Paine Webber can woo investors who want to own stocks yet worry about the risks. “The trusts are designed for people who want to sleep at night,” says Linda Buckley, Paine Webber’s national sales manager for unit trusts in Weehawken, N.J.
Paine Webber levies a 4.5% up-front sales fee on its Pathfinders Trusts. The Lord Abbett Equity Fund, which closed to new investors on May 31, coincidentally also carries a maximum front-end charge of 4.5%. The company plans to offer a second insured stock fund in the near future, presumably with the same sales expense.
If you don’t want to pay these fees, or if you want more flexibility, you could build your own “guaranteed” portfolio. For example, you might invest in a growth stock fund of your choice along with individual zero-coupon Treasuries, which can be purchased through various brokerages.
Or you could buy mutual funds that hold zero-coupon bonds maturing on a specific date. Two no-load firms, Benham Capital Management of Mountain View, Calif., and Scudder Funds of Boston, offer zero-coupon bond portfolios.
As nice as it seems to have a stock market safeguard, there’s a problem with this approach: inflation. Simply put, it wouldn’t be such a great deal if you get the same amount of money 10 years from now that you invest today, because inflation will have eroded your purchasing power in the meantime.
However, that’s a chance you might have to take if you want equity growth without stock market volatility.
TIME AS AN ALLY The longer you stay invested in the stock market, the better your chances of success.
That’s what Financial Security Assurance is betting on in agreeing to insure investors against losses on the Lord Abbett Equity Fund. FSA promises to guarantee the initial principal of original shareholders on the fund’s 10th anniversary in the year 2000, assuming dividends and other distributions are reinvested. Based on historic market data, there’s a low likelihood that the fund will lose money by the maturity date.
This table, using data compiled by Ibbotson Associates of Chicago, shows multiyear periods during which the Standard & Poor’s 500 and its predecessor index lost money (after including reinvested dividends) and the size of each decline.
Bearish Periods, 5 Years:
1927-31: -23.0%
1928-32: -48.6%
1929-33: -44.9%
1930-34: -40.7%
1937-41: -32.3%
1970-74: -11.3%
1973-77: -1.1%
Bearish Periods, 10 Years:
1929-38 -4.4%
1930-39 -0.3%
Bearish Periods, 20 Years:
None
HOW MUTUAL FUNDS PERFORMED
Average total return, including dividends, in percent for periods ended Thursday, June 7
TOP 10
Fund Type Notes 12 mos. Yr. to date WEEK Fidelity Select Savings & Loan FS LL,R -7.25% 7.36% 5.39% Fidelity Select Financial FS LL,R -1.99 2.68 4.75 Wexford Trust: Muhlenkamp Fund FX NL 7.43 5.44 4.02 Benham Target: Series 2020 FI NL * -7.33 3.93 Bruce Fund G NL 27.01 14.11 3.92 Benham Target: Series 2015 FI NL 3.44 -7.12 3.92 Fidelity Select Regional Bank FS LL,R -7.09 -3.21 3.83 Boston Co. Invest.: Contrarian G NL 5.55 5.60 3.82 FPA Capital Fund G L 13.38 14.57 3.81 SAFECO Growth Fund G NL 16.74 12.47 3.26
BOTTOM 10
Fund Type Notes 12 mos. Yr. to date WEEK Strategic Investments AU L -8.20% -40.83% -12.54% Strategic Gold/Minerals AU L -14.76 -0.27 -11.97 Strategic Silver S L 18.72 -0.89 -11.91 Benham Equities: AU NL 6.73 -19.04 -10.31 Gold Eq. Index Rushmore Precious Metal Index AU NL * -20.70 -9.91 Financial Portfolio: Gold AU NL 5.77 -17.59 -9.39 U.S. Gold Shares AU NL 9.53 -26.74 -8.69 International Investors AU L 11.17 -22.94 -8.59 Fidelity Select American Gold AU LL,R 4.84 -13.31 -8.39 Fidelity Fidelity AU LL,R 4.94 -17.87 -8.28 Precious Metals
TYPE: AU = gold, B = balanced, CA = capital appreciation, CV = convertible securities, EI = equity income, EU = European regional, FI = fixed income, FS = financial securities, FX = flexible portfolio, G = growth, GI = growth and income, GL = global-international and U.S. stocks, GX = global flexible portfolio, H = health/biotechnology, I = income, IF = international, MI = mixed income, NR = natural resources, OI = option income, PC = Pacific regional, RE = real estate, S = specialty/misc., SG = small company, TK = science and technology, UT = utility, WI = world income.
NOTES: NL means no sales charge, LL means sales charge of 4 1/2% or less; L means sales charge of greater than 4 1/2%; R means redemption fee may apply.
* Fund not in existance for the period covered.
Source: Lipper Analytical Services
