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Principal-Protection Funds Don't Live Up to Their Promise

Despite all the hype, even their own managers won't buy these funds.

Russel Kinnel, 06/05/2006

Always be wary of a fund whose strategy sounds more like a marketing pitch.

"Get exposure to stocks without any of the downside."

That's the pitch of principal-protection funds, and it sounds pretty compelling. If you just hold the funds for five years, you'll get your principal back, as well as possibly some price appreciation to boot. Principal-protection funds buy stocks to give investors market exposure, but they also guarantee the investor's principal by buying bonds and possibly an insurance wrapper.

Unfortunately, the funds don't live up to their promise. We were wary of these funds from the beginning, and time is bearing out those views. Most of the funds have produced dismal returns. In fact, about half haven't even made it back to their original $10 share NAVs.

The basic flaw of these funds is that because the fund companies or the insurance companies that guaranteed investors' principal have a strong incentive to protect themselves from paying out of their own pockets, they position the funds so conservatively that they are sacrificing the upside. In fact, funds with an insurance wrapper have to let the insurer make the asset-allocation decision--so of course the insurer is going choose something super-conservative to protect it from having to pay off.

So you get principal protection, but you get very little stock exposure. And you get lots of fees. The average expense ratio of principal-protection funds is a nasty 2.06%. Now consider that the average return is about 3.3% annualized over the trailing three years and you realize that the fund companies and insurers are taking almost a dollar for every dollar you get out of such a fund. Principal-protection funds' three-year return lags the S&P 500 by a whopping 1,100 basis points while just eking out a 70-basis-point lead on the Lehman Brothers Aggregate.

I should note, though, that Merrill Lynch Basic Value Principal Protection MDPVX has surpassed its competition and actually delivered respectable results. The fund has produced returns of 9.6% annualized over the trailing three years and charges a more reasonable expense ratio. The fund has the next-closest principal-protection fund beaten by nearly 300 basis points because it has much more in equities in addition to lower costs.

Apparently, we're not the only ones who aren't buying the idea behind principal-protection funds. It turns out that the fund managers themselves haven't been buying the funds, either. In fact, I've looked through the SEC filings, and I haven't found a single principle-protection fund in which the managers invested a dime of their own money.

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