Investors Seek Solace in Protected Funds but Can Miss Market Gains

After three years of shrinking portfolios, who can blame battered investors looking for a little assurance?

A growing number of them are seeking it through principal-protected mutual funds. These funds promise investors the return of their initial investment without giving up the chance to participate in a stock market rebound.

The first principal-protected funds appeared in 1999, and so far $6.25 billion has flowed into them, most of it in the last year, according to Financial Research Corp., a mutual fund research consulting firm in Boston.

“It appeals to investors looking for safety. They’ve been hit so hard by the market in the past three years,” said Kristin Adamonis, a research analyst with Financial Research.

The funds have plenty of critics, though.

“It’s the most expensive, confusing, market-driven, conservative investment being sold right now,” said Brian Portnoy, senior analyst with fund tracker Morningstar Inc. in Chicago.

Given the funds’ growing popularity, the NASD, formerly known as the National Assn. of Securities Dealers, recently issued an investor alert on the funds and their potential risks.

“They are not a typical mutual fund,” said John Gannon, the NASD’s director of individual investor services.

Here’s generally how many of the funds work:

Investors buy shares during an offering period lasting several weeks or months. They are guaranteed the return of their initial investment, minus any upfront sales charges, provided they follow certain rules.

Their money, for instance, must remain in the fund for a specified period, usually five to 10 years. All dividends and other distributions must be reinvested.

Of course, investors can take their money out early, though often at a cost. They lose the guarantee, so if they are selling shares that have fallen in price, they could take a loss. Some funds charge a fee for early withdrawals.

The funds guarantee the principal typically by taking out an insurance policy and making an agreement with the insurer to limit risk, Gannon said. Often risk is reduced by investing heavily in zero coupon bonds and other debt backed by the U.S. government, he said.

What’s left is invested in stocks, which may not be much.

In a very volatile stock market, most, if not all, of the fund’s assets could be in bonds, Gannon said. Currently, some funds have just 1% to 2% of assets in stocks, a level that won’t allow them to participate much in a sudden market rebound, experts say.

“A lot of investment decisions are not just a manager deciding what are the best investments given current market conditions,” Gannon said, “but are controlled by the insurance contract itself. An investment manager can’t all of a sudden say, ‘I think the market will go higher two weeks from now, so I’m going to move 75% of my money into stock.’ He may or may not be able to do that based on the insurance contract.”

Guaranteeing the principal comes at a cost, and these funds have much higher fees than others do, experts say.

Depending on the class of shares an investor buys, annual fees can range from 1.75% to 3%, according to Financial Research.

“It sounds really good to investors. When you look at it more closely, they are very expensive and you have to ask, ‘Am I getting a reward? Am I paying too much for this protection?’ The answer is probably ‘yes,’ ” said Kathryn Barland, a senior research analyst with Lipper Inc. Other funds holding investments similar to those held by principal-protected funds on average charge less than 1% a year, she said.

Barland said investors can build principal-protected portfolios for themselves -- with more flexibility and lower expenses -- by buying a mutual fund that invests in U.S. Treasury bonds and a low-cost stock fund.

But Adamonis of Financial Research warned: “Most regular customers don’t have the investing background to go into the market” to build a principal- protected portfolio. Still, she added, the high sales figures indicate that some investors may be buying the funds out of fear and may become unhappy with them later.

Before committing money to one of these funds for years, read the prospectus and ask yourself whether the fund fits your investment objectives, Gannon of the NASD advised.

“Do you need the money in the next five to 10 years? Do you need income from the investment?” he said. “Because of the way that guarantee works, this isn’t really the best investment to do that.”

Also, you need to ask yourself whether you are bearish for the long haul or just feeling burned for the moment.

“Do you really anticipate that 10 years out, you will need the guarantee?” Gannon asked. “Because there is a chance that based on market conditions, you may not fully participate in market increases with a principal-protected fund.”