Principal-Protected Funds—Security Has a Price
The recent bear market has left many investors worried more about securing the return of their investment dollars than about the return on their investments. Financial product providers have responded by marketing new types of mutual funds that pledge to guarantee, for a set period of time, that the capital you invest in the mutual fund will be kept safe—for a price. These products are known as "principal protected" funds (or, alternatively, "principal protection," "capital preservation," or "guaranteed" funds)1. Before you invest in a principal-protected fund, it is important to understand how they work and what they cost.
What are Principal-Protected Funds?
There are several common characteristics shared by these investments:
- Guarantee principal. Most principal-protected funds guarantee your initial investment minus any front-end sales charge even if the stock markets fall. In many cases, the guarantee is backed by an insurance policy.
- Lock-up period. If you sell any shares in the fund prior to the end of the "guarantee period"—a period of anywhere from 5 to 10 years—you lose the guarantee on those shares and could lose money if the share price has fallen since your initial investment.
- Hold a mixture of bonds and stocks. Most principal-protected funds invest a portion of the fund in zero-coupon bonds and other debt securities, and a portion in stocks and other equity investments during the guarantee period. To ensure the fund can support the guarantee, many of these funds may be almost entirely invested in zero-coupon bonds or other debt securities when interest rates are low and equity markets are volatile. Because this allocation provides less exposure to the markets, it may eliminate or greatly reduce any potential gains the fund can achieve from subsequent gains in the stock market. It also may increase the risk to the fund of rising interest rates, which generally cause bond prices to fall.
Zero-coupon bonds, unlike most bonds, pay no interest (or zero coupons). Instead, you buy them at deep discounts below face value. When the bond matures, you receive the face value, which represents the principal plus interest that has accrued. Because zero coupons don't pay any interest until maturity, their prices may be more volatile than other bonds with similar maturities that pay interest periodically. To learn more about zero-coupon bonds, please visit Smart Bond Investing.
- Higher fees. Many principal-protected funds carry an expense ratio (the total annual fees deducted from your holdings) that typically is higher than that of non-protected funds. Fees range from 1.5 percent to nearly 2 percent, of which .33 percent to .75 percent typically pays for the principal guarantee. In addition, many funds also impose sales charges, plus redemption/penalty fees for early withdrawals that may be significant.
Mutual Fund Expenses and Breakpoints
Checking up on expenses
Like most investments, all mutual funds charge fees and expenses that are paid by investors. These fees and expenses can vary widely from fund to fund or fund class to fund class. Because even small differences in expenses can make a big difference in your return over time, we've developed an expense analyzer to help you compare how sales loads, fees, and other mutual fund expenses can impact your return.
Getting a break with breakpoints
If the principal-protected fund you are considering investing in charges a front-end sales load, you may be able to get a discount for larger investments. The investment levels at which the discounts become available are called "breakpoints." Learn how breakpoints work and what you need to know to make sure you are charged the lowest possible front-end sales load.
How Principal-Protected Funds Work
Principal-protected funds typically consist of three phases:
- Subscription or offering phase. A period of several weeks or months when investors can purchase shares in the fund that will be subject to the guarantee.
- Guarantee phase. If you hold your investment throughout this 5-to-10-year period and reinvest all dividends and distributions, your initial investment minus any front-end sales load is guaranteed.
- Post-guarantee phase. After the guarantee phase, the fund either liquidates or operates without any guarantees. If the fund continues to operate, it also may change its investment objectives and focus on an equity-only strategy.
Issues to Think About
Principal-protected products are different than traditional mutual funds and differ from one another. You should read each prospectus carefully. But in general, here are some factors you should bear in mind before investing:
- Do you need your money in the next 5 to 10 years? If you liquidate an investment in a principal-protected fund early, you may lose your principal guarantee, have to pay an early withdrawal penalty, and could lose money if the share price has fallen since your initial investment.
- Do you need any income from the investment? The guarantee is based on taking no redemptions during the guarantee period and reinvesting all dividends and distributions. Although reinvested dividends and distributions will not add to the amount that is guaranteed, your election to make redemptions or receive dividends or distribution in cash can reduce the guaranteed amount.
- Unless held in a tax-deferred retirement account, you must pay U.S. income tax yearly on the imputed interest from the fund's zero-coupon bond holdings as it accrues. This is true although no actual cash distributions are paid into your account from the zero-coupon bonds held in the fund's portfolio.
- In certain market conditions, the fund may be invested entirely in zero-coupon bonds and other debt securities. This could mean forfeiting all potential gains should stock prices rise.
- You might achieve no gains above your initial investment. In this case, your performance would trail that of Treasury bonds purchased with no annual fees.
- You will only receive the benefit of the guarantee on the maturity date. For most principal-protected funds, the guarantee is only valid on the fund's maturity date, usually the last day of the guarantee or lock-up period. If you sell your shares of the fund before or after the maturity date, you could lose money if the share price has fallen.
- How good is the guarantee? The guarantee the fund provides is only as good as the company that gives it. While it is an uncommon occurrence that the banks and insurance companies that typically back these guarantees are unable to meet their obligations, it happens. There are several credit rating agencies that rate a company's financial strength. Information about these firms can be found on the Securities and Exchange Commission (SEC) website.
Beware of Exaggerated Claims
Beware of sellers of principal-protected funds that exaggerate the benefits of these funds, such as an assertion that the fund "will beat the performance of the Standard & Poor's 500-stock index." While this may be true during a bear-market period when stock prices are falling and principal depreciating, it is clearly not true during an extended bull market in which stock prices for broad-based indexes are rising sharply.
As with any investment, be sure you understand the basis on which performance claims are being made.
Risk and Return
Each investor must find his or her own comfort level as regards risk and capital growth potential, and all types of investments, including principal-protected funds, involve a trade-off between risk and return. While principal-protected funds do provide a guarantee, you'll pay for this security with higher than average fund expenses and potentially lower long-term capital gains.
- Investor Alert, Understanding Mutual Fund Classes.
- Investor Alert, Mutual Fund Breakpoints: A Break Worth Taking.
- Fund Analyzer
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1 Some variable annuities also offer a principal protected sub-account or rider (also known as a guaranteed minimum accumulation benefit). While this Alert focuses on principal protected mutual funds, much of the information is also applicable to these variable annuity products.