We'll Pass on Principal-Protection Funds

Wall Street's implosion has revealed just how risky so-called safe investments can actually be. As some have learned the hard way this year, auction-rate preferred securities really aren't the same as cash, and money-market funds can break the buck. Yet finance wizards, unbowed by recent failures, will continue to engineer and market supposedly safe securities.

That's why we're raising a cautionary note on one trend likely to rear its head again as market volatility drives worried investors to perceived safe havens: "guaranteed" mutual funds. Known alternatively as principal-protected, principal-protection or capital-preservation funds, these mutual funds promise to some degree to preserve your initial investment even if the market goes to hell. (Specific protections vary by fund, so read the fine print.) They attracted attention in the bear market of 2000-02 but lost favor as stocks went on a five-year bull run that started to reverse in late 2007. The environment is ripe for a comeback.

DWS Investments launched two such funds earlier this year, DWS LifeCompass Protect (PROAX) and DWS LifeCompass Income (INCAX). The company describes them as "designed to deliver principal protection, capital appreciation and consistent income for retirees as well as investors preparing for retirement." Both funds offer some form of guarantee through a financial warranty from Merrill Lynch (MER), which is being sold to Bank of America (BAC) because Merrill couldn't survive the credit crisis on its own.

Also in the works is something from John Hancock Financial Services, which is awaiting SEC approval to offer mutual funds with a warranty. A company spokesperson confirmed this is still pending, but declined further comment.

The case for such products is that they’re a worthy idea for risk-adverse investors, because they offer at least some semblance of security and upside at the same time. Who doesn’t want that?

Why begrudge such efforts?

In the last bear market, Ben Franklin, a financial advisor in Urbana, Ill., says he tried some of ING's (ING) principal-protection funds for risk-averse clients. But "you end up getting less than CD rates of return for a fund that's supposed to get equity returns," Franklin says. "We're still trying to find some fund with protection, but we just weren't happy with our experience."

Currently, investors have $1.34 billion in principal-protected mutual funds from firms including ING, Oppenheimer and BlackRock (BLK), according to Financial Research Corp. (See chart below). That's down from $2 billion in principal-protected funds counted by Lipper back in 2003-04, and the drop is probably for the better.

As the credit meltdown shows, no real investment is 100% guaranteed. Any "guarantee" is only as good as whoever is backing it, and especially after this year we're hard-pressed to rely on insurers, banks or financial wizardry to guarantee anything. Consider that Lehman Brothers sold Principal Protected Notes that are now worthless.

It's unclear how Merrill's sale to Bank of America will affect DWS funds covered by the Merrill warranty, and DWS couldn't make anyone available to comment.

But even assuming third-party backers make good on their guarantee, what's in it for them? Well, for one, fees. You'll pay a steep price for this insurance. At the same time, insurers have an interest in limiting their risk to make money off the product. This means the fund may be mostly invested in things unlikely to earn you a return, such as zero-coupon bonds. The Financial Industry Regulatory Authority has issued an investor alert to this effect.

DWS LifeCompass Protect, for instance, has a 5.75% upfront sales charge, a 1.7% expense ratio and 66% of its assets in U.S. Treasurys. The rest is invested in low-cost index funds. You could create this portfolio yourself for much cheaper. In addition, the fund is down 12% this year.

"As of today I think they're a terrible idea," says Jason Whitby, a financial advisor in Coconut Grove, Fla. Instead, he says, you could just take 85% of the money you'd put into such a fund and save it in a five-year CD. Then put the remaining 15% into a low-cost S&P 500 index fund. "You'd be guaranteed the same output and better return because there are no fees."