Taking the Downside Out of Investing

You don't need a pricey fund to preserve your principal

Who wouldn't like an investment that allows you to participate in a stock market recovery while guaranteeing that you'll get your money back if the market continues to fall? That's exactly what a small but growing number of mutual funds, generally known as principal protected funds, promise if you leave your money with them for a set period, usually 5 or 10 years. These vehicles let you "sleep at night," says Bob Williams, a financial adviser at Delta Trust Investments in Little Rock, who moved about $2 million of client money into a principal protected fund as the market started falling in early 2000.

If you're tempted to put your retirement stash into one of these funds--which work their magic by blending stocks and bonds--think carefully about it. Many funds levy sales charges as high as 5.5% when you go in or exit, and ongoing annual expenses average 1.5%. That's nearly half a percentage point more than balanced mutual funds, which also mix stocks and bonds. "They offer a very expensive guarantee," says David Bugen, a financial adviser at RegentAtlantic Capital in Chatham, N.J.

But you don't need investment managers Scudder or ING--two firms that offer these funds--to have a principal protected plan. You can do it yourself and save on fees and sales charges.

Most principal protected funds safeguard shareholders' principal by investing a large chunk of the investment in zero-coupon bonds. Such bonds don't make regular interest payments. Instead, they're purchased at a discount to their face value, pay off in full at maturity--and the difference is the interest.

To cover a $100,000 investment, for example, an investor could buy 100 zero-coupon U.S. Treasury bonds that pay $1,000 each upon maturity. Because zeros are sold at deep discounts, it might cost only $80,000 to buy bonds today that will deliver $100,000 in five years. With the remaining $20,000, you can buy stock mutual funds--preferably no-load, low-expense index funds--thus positioning yourself to gain if the market rises.

Whether you undertake this strategy yourself or buy a principal protected fund, you're going to end up heavily in bonds. That's because with interest rates low, bond prices are relatively high, leaving little left over for stocks. If stocks recover and make modest gains--say, 30% over the next five years--the stocks and bonds together will be worth $126,000, a 26% return. Had you invested the entire amount in stocks, you would only have a little bit more, $130,000 (table). You can consider the $4,000 difference the price of the principal protected strategy's guarantee. If the market rebounds strongly, that cost goes up. With a 50% gain in stocks, the principal protected strategy would only deliver 30%--not much more than the return in the first example.

Principal protection has other drawbacks. To get a guarantee, it's necessary to lock up your money for a long time. If you invest on your own, you'll need to wait until your zero-coupon bonds mature before recouping your principal. Scudder's funds require you to put your money away for a decade, while ING's eight funds issue five-year guarantees. You can sell your fund shares before they mature. But you'll receive the price at which they trade on that day--which may be more or less than what you paid.

Nor is this investment strategy tax-friendly, notes Eric Jacobson, senior analyst at fund tracker Morningstar. Unless you buy zero-coupon bonds in a tax-deferred retirement account, you must pay income tax on the interest they earn annually even though you are not getting the cash. Many funds allow you to take out your dividends and taxable distributions in the year in which they accrue. However, the funds also reduce your guaranteed principal by the amount of these distributions.

So if a principal protected investment plan appeals to you, take this advice: Build it yourself.

Corrections and Clarifications In "Taking the downside out of investing" (BusinessWeek Investor, July 29), a table incorrectly stated that $100,000 invested in a portfolio composed 80% of zero-coupon bonds and 20% of stocks would yield $100,000 in the event of a 10% market decline. The correct value is $118,000. The table also incorrectly stated that the same portfolio would be worth $100,000 if the market were to remain flat. In fact, the portfolio would be worth $120,000 under those circumstances.

By Anne Tergesen

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