Fund Watch
Avoid This Principal-Protection Fund
The new S&P 500 Capital Appreciation sounds great ... until you read the fine print.
By Elizabeth Ody, Associate Editor, Kiplinger's Personal Finance
March 12, 2009
Trying to chase a horse that's already out of the barn is one of the oldest mistakes in the investing playbook. Take it from anyone who bought tech stocks in early 2000, real estate investment trusts in 2006 or energy stocks in the spring of 2008. Just as those investors fell victim to their insatiable lust for big and quick profits, many today are paralyzed with fear. And the newly launched S&P 500 Capital Appreciation fund, which vows to protect investors' principal investment over the next ten years while tapping the market's gains, is now here to catch them.
As a marketing gimmick, the timing of the fund's launch couldn't be better. Investors have just witnessed the crushing demolition of their savings -- from its peak in October 2007 through March 11, Standard & Poor's 500-stock index tumbled 54%. And as the ten-year Treasury note's historically low yield of 2.98% shows, many investors are willing to accept a miniscule return for protection from big losses.
But there could hardly be a worse time to invest in such a fund. Although the fund loosely tracks the S&P 500, it stunts the returns you'll reap from the index's gains with heavy costs. And with the index hovering close to a 12-year low, U.S. stocks are offering investors opportunities for appreciation that haven't been available in years.
At first glance, S&P 500 Capital Appreciation (symbol SSPAX) sounds like a home run. The fund vows to return at least 150% of your principal in ten years, provided you invested at inception, less fees and expenses. But it also lets you capture the potentially boundless gains of the S&P 500.
But then there's the fine print. Those fees and expenses knock your 150% minimum return down to about 119% -- for an annualized gain over ten years of 1.73%. You're only promised a return of your principal if you hold on until the fund's "special redemption" date, on December 1, 2018 (after that date the fund will turn into an ordinary S&P 500 index fund). As for those potentially boundless gains of the S&P 500? That only refers to the value of the index. You can kiss dividends goodbye.
Finance geeks may get a kick out of the clever engineering under the hood. The fund is run by Structured Investment Management (SIM), a relatively new firm whose raison d'etre is to make complex structured investments available to the average Joe and Josephine. With the fund's assets, the managers buy individual stocks and futures on the S&P 500. But they also buy put options on the index, or the option to sell stocks for a set price, corresponding to 150% of the value of the S&P on the date the fund began investing (which was February 8, when the S&P 500 closed at 870). On any given day, the value of the puts will move in the opposite direction as the value of the S&P, so by definition the fund will be less volatile than the market.
Purchasing that protection isn't cheap, however. The cost of buying those put options accounts for roughly two-thirds of the difference between your hypothetical 150% minimum return and your actual 119% minimum return.
In fact, the fund is cost-heavy on all sides. The class A shares come with a 5% front-end sales charge and an annual 12b-1 fee of 0.25%. Once you factor in that sales charge, your minimum 1.73% annualized return shrinks to 1.21%. Ramesh Menon, SIM's founder and the fund's manager, says that, assuming the principal protection doesn't kick in, operating expenses and the costs of the S&P puts will cause the fund to lag the index by 1.6 percentage points per year, on average.
The hope, of course, is that the market goes up and you're not relying on the principal protection to kick in. In that case, the importance of the dividends for which you won't receive any credit can't be understated. Over the past ten years through March 11, the S&P 500 is down 5.7% annualized when you look at price appreciation alone, but only down 4.06% annualized when you factor in dividends. On a $10,000 investment made ten years ago, that works out to more than a $1,000 difference. With the S&P index currently yielding 3.4%, dividends will play an even greater role in future returns.
Menon thinks this type of fund could be a serious contender to replace target-date retirement funds. Target-date investors "need to be invested in the stock market because that's where the returns have been, historically, but because these people know for sure they're going to need a particular amount of money at a particular time, they can't take any risk with respect to their principal amount over that time," he says. "So this gives you an in-between choice."
To be sure, this kind of a safety net could have been a great asset over the past ten years. But it's the sheer immensity of the past decade's decline that makes it unlikely that the market's performance over the next ten years will look anything similar. Instead of hunkering down in some contraption that plays on their fears, long-term investors should look to take advantage of the most favorable buying opportunity in a generation. A great way to do that is by buying a pure index fund, such as Vanguard Index 500 (VFINX) or an exchange-traded fund such as SPDR S&P 500 ETF (SPY). Yes, the ride will be wilder, but the rewards will almost surely be higher.
Reader Comments (9)
Posted by: Praveen at 03/12/2009 04:03:39 PM
Thanks for bringing this to our(readers) attention. Am surprised at how complex this fund is structured so the only people who benefit and gain the most are the fund managers themselves. Shame on them!!!!
Posted by: Ann at 03/12/2009 06:49:01 PM
Thank you for the update. Fortunately, this fund is not part of my 401(k) plan.
Posted by: snm at 03/13/2009 11:54:16 AM
Wall street and their money managers continue to prey on investors' fears, hoping that investors haven't learned a thing. Very sad indeed!
Posted by: Ramesh Menon at 03/13/2009 05:51:14 PM
Elizabeth - your article advises retirees to risk their life's savings based on your view that the market will be "almost surely" higher in ten years time. There are many retirees that cannot risk taking such a view and for whom a principal-protected solution is appropriate. Your article fails to point out the superior characteristics of this principal-protected fund versus other principal-protected alternatives such as principal-protected notes, variable annuities and other principal-protected funds.
Posted by: Bob at 03/14/2009 09:10:27 AM
I've noticed that at least one financial manager in my area is pushing new annuities with guaranteed returns of 10-12%. While the verbal guarantee sounds tempting, the fine print doesn't. Always read the fine print!!!
Posted by: Jim at 03/16/2009 10:04:53 AM
"Instead of hunkering down in some contraption that plays on their fears, long-term investors should look to take advantage of the most favorable buying opportunity in a generation". Oh dear... Why am I wasting my time listening to this "journalist"...
Posted by: Michael at 03/16/2009 10:17:10 AM
I feel that products like this prey on people who are financially uneducated and operating out of fear. Those expenses are really high and you can't recoup them. One of things that I've learned about the state of this economy is that it's the most amazing time to buy stocks. A lot of people don't seem to get the point that bear markets happen and that's part of investment. If you plan and prepare for that, you will do fine regardless of how the market is doing.
Posted by: anon at 03/22/2009 08:00:47 PM
"But it's the sheer immensity of the past decade's decline that makes it unlikely that the market's performance over the next ten years will look anything similar."........... Too bad there is no statistical or empirical validity to this statement whatsoever!! If you flip a coin 9 times in a row and get heads every time your probability of getting heads on the tenth flip is still 50%. Many a fool have lost loads of money chasing after a "good run of bad luck". More specifically this is due to misinterpreting the concepts of mean reversion and the law of large numbers. In practice this states that over many observations, stocks will revert to their long-term average. The problem is when people try and interpret when stocks are due to revert to the mean after a relatively short period of time (10 years is still a short period compared to measurable stock returns going back to 1896...if you disagree look at a chart of the S&P or DJIA from 1965 to 1982). Personally I believe we are due for a rally at some point but the author is pushing her make-believe opinion as fact in this case, which I disagree with. She shouldn't feel too bad because this is a common investor bias according to behavioral finance (the study of common psychological traits that cause investors to unintentionally make irrational decisions that are not in their own self-interest).
Posted by: Yikes! at 03/24/2009 11:28:45 AM
Uh oh. Looks like someone has been drinking too much stock market kool-aid. You, a journalist, just advised people to put their retirement money into the S&P 500 without any downside protection. You didn't even mention diversification. You just went directly into comparing this product to a 100% pure stock play. This product seems to be designed for capital preservation first, and capital appreciation second. It's not trying to beat the S&P 500. Not even trying to match it. This product is clearly for the people who can't afford the risk of a loss... but perhaps also want the chance to earn more than 0% to 2% they might get in a money market. You need to compare the return potential of this product vs other products with similar risk: money market, short term bonds, savings accounts, CDs, or cash under the mattress. Your advice is the same as saying someone could just bet their life savings on one hand of black jack in Vegas, and if they win, they could double their money. But what if they lose? As for fees, there is an old saying: "Fees are only relevant in the absence of a competitive advantage." If this product delivers as promised, fees are irrelevant... UNLESS you can find another product that offers the EXACT same service(or better) for a lower fee. You are comparing apples to oranges. People who can afford to take risk probably don't need this product. But for people who are risk averse, they may just like it better than many other low-risk investments. I am not saying this is a good or bad product. Many annuity products may offer a better solution, with similar features, shorter holding periods and lower fees. But your misunderstanding of this product is symptomatic of a huge problem we have in this country -- the media's wide-spread misunderstanding of the markets, and the problematic reporting that comes it. You really might want to consider a re-write of this entire article.