Even the managers won't buy these funds

By Morningstar

Always be wary of a fund whose strategy sounds more like a marketing pitch.

Get exposure to stocks without any of the downside. That's the pitch of principal-protection funds, and it sounds pretty compelling. If you just hold the funds for five years you'll get your principal back, as well as possibly some price appreciation to boot. Principal-protection funds buy stocks to give you market exposure, but they also guarantee your principal by buying bonds and possibly an insurance wrapper.

At the risk of causing you to feel a little weltschmerz, I have to tell you the funds don't live up to their promise. We were wary of these funds from the beginning, and time is bearing out those views.

Fees eat up the returns

Most of the funds have produced dismal returns. In fact, about half haven't even made it back to their original $10-per-share net asset values (NAVs).

The basic flaw of these funds is that because the fund companies or the insurance companies that guaranteed investors' principal have a strong incentive to protect themselves from paying out of their own pockets, they position the funds so conservatively that they are sacrificing the upside. In fact, funds with an insurance wrapper have to let the insurer make the asset-allocation decision -- so of course the insurer is going to choose something super-conservative to protect it from having to pay off.

So you get principal protection, but you get very little stock exposure. And you get lots of fees. The average expense ratio of principal-protection funds is a nasty 2.06%. Now consider that the average return is about 3.3% annualized over the trailing three years, and you realize that the fund companies and insurers are taking almost a dollar for every dollar you get out of such a fund. Principal-protection funds' three-year return lags the S&P 500 ($INX, news, msgs) by a whopping 1,100 basis points while just eking out a 70-basis-point lead on the Lehman Brothers Aggregate.

I should note, though, that Merrill Lynch Basic Value Principal Protection (MDPVX) has surpassed its competition and actually delivered respectable results. The fund has produced returns of 9.6% annualized over the trailing three years and charges a more reasonable expense ratio. The fund has the next-closest principal-protection fund beaten by nearly 300 basis points because it has much more in equities in addition to lower costs.

Managers don't buy it, either

Apparently we're not the only ones who aren't buying the idea behind principal-protection funds. It turns out that the fund managers themselves haven't been buying the funds, either. In fact, I've looked through the SEC filings, and I haven't found a single principle-protection fund in which the managers invested a dime of their own money.

TA Index Protected Principal Stock (IPPAX) is managed by J. Patrick Rogers, and he has nothing in the fund. Oppenheimer Principal Prot Main St (OAPPX) managers Angelo Manioudakis' and Rudi W. Schadt's investment: 0. At Pioneer Protected Principal Plus (PPPAX), managers John Carey, Walter Hunnewell and Richard Schlanger have $0 between them in the fund.

ING runs 12 principal-protection funds, and its managers don't have a dollar in any of them, nor do any of the directors. That's a lot of goose eggs.

Better alternatives

If you're really bothered by losing any money, even for a short period of time, buy a low-cost short-term bond fund. It won't make much money, but you won't likely be in the red for more than a few months -- and even then it will be a small amount.

A better idea, though, would be to invest in a low-cost target-date fund whose date matches your investment time horizon. After all, what most investors are really worried about is the value of the investment as they near the time they plan to sell. Target-date funds enable you to take more risks when there is more time to recoup any losses, but they shift to bonds as the time draws near when you want that added protection.

There are no guarantees with such funds, but they should actually come a lot closer to delivering the promise that principal-protection funds make. Click here for a list of our target-date Fund Analyst Picks (membership required).