Investments for the faint of heart

Launching a fund amid market turmoil may be a challenge, but one fund creator sees opportunity with a fund designed for the risk-averse. The S&P 500 Capital Appreciation Fund, offered by Structured Investment Management Inc. of New York, is a 10-year principal-protected mutual fund that tracks the Standard & Poor's 500 stock index. At the end of 10 years, the net asset value of the investment will be at least 150% of the initial NAV, less fees, expenses and costs. For a Class A share, the firm estimates a minimum NAV of approximately 119.4%. The principal is protected with a guarantee from a bank, achieved by purchasing put options that are embedded in swaps, said SIM chief executive Ramesh Menon. "All of those protected arrangements are fully secured in cash on a daily basis," he said. "We buy protective options on the S&P from these banks, and these contracts provide the floor on the NAV. The contracts are in place at all times. The fund is fully hedged from a market risk perspective." Additionally, the fund employs credit default swaps to protect against the default of a counterparty, Mr. Menon said. There is a 1% redemption fee prior to the 10-year period.

THE PRICE

The guarantee has a price, advisers said."There's not a lot of risk, but there's not a whole lot of return," said Chuck Gibson, owner of Financial Perspectives of Newark, Calif., which has $50 million in assets under management. "It's an interesting fund. But the fees are high. You get the upside. I think there are better investments out there." The expense ratio is 0.89% for Class A and 1.64% for other shares. The estimated "economic costs" for the swaps and dividend-related costs is 4.51%. The swap payments won't start to eat into the investor's return unless the markets go up by more than 50%, Mr. Menon said. "Payments associated with the swap contracts can cause the fund to underperform the index," Mr. Menon said. The average underperformance relative to the index is approximately 1.80%, according to a Monte Carlo simulation, he said. The 74 principal-protected funds tracked by the New York-based research firm Lipper Inc. have about $1.35 billion in assets. The average expense ratio is $1.96%, and average returns are -3.27% for the one-year trailing period as of Aug. 31, 0.84% for three years, 1.95% for five years and 4.99% for 10 years. "The biggest complaint from investors is that you don't get to fully participate in the upside of the market," said Tom Roseen, senior research analyst at Lipper. The fund may work for investors who don't need the principal, such as retirees or participants in Section 529 college savings plans, he said. Another concern is when to buy. "If you're going to buy into one of these funds, you want to buy in high because you are going to pay a fee for the downside protection," Mr. Gibson said. "In a down market, you have a much higher probability of it going up than down. You want to pay for that [protection] only if you have to." "Investors will benefit from positive market performance and will have protection on the downside," Mr. Menon said. "The product is designed for investors that have a roughly 10-year investment horizon. They are long-term investors and not market timers. To the extent that an investor has the ability to successfully time the market, clearly, they don't need the protection." Still, the use of derivatives and swaps can give investors pause. "Look at all the companies that are in trouble right now because of all the derivatives," Mr. Gibson said. "A-rated doesn't mean a whole lot anymore." The protection is needed more for the short term, said Joe Alexopolous, principal of Aequitas Wealth Management LLC of Los Angeles, which manages $20 million in assets. "Since 1926, there were only two 10-year periods that the stock market had negative returns," Mr. Alexopolous said. The fund is better-suited to a retirement plan, he said. "It has to go into a qualified plan to get over the tax handicap. Your return is taxed like ordinary income." Investors want safety, said Ted Toal, senior partner with Triton Wealth Management LLC of Annapolis, Md., which manages $90 million in assets. "You definitely see products like this coming out during market volatility," he said. "People like to hear 'principal-protected' and 'guaranteed.' But that's not necessarily what they need." E-mail Sue Asci at sasci@investmentnews.com.