In the wake of the financial crisis, almost all investors are looking for safety. As a result, financial firms are peddling a number of investments that promise protection of your principal, regular monthly payouts or guaranteed minimum returns.
But beware, many of these products aren't all they're cracked up to be. Some don't meet their goals, and many charge high fees.
"They may all be appropriate for some investors," says Harold Evensky, president of Evensky & Katz, a financial advisory firm in Coral Gables, Fla. "But to overplay their safety without risk would be irresponsible. If it all works, you're safe in protecting principal, but there is no guarantee. Some of these clearly have market risk. There is no guarantee managers will achieve their goal."
Among the products touting safety are principal-protected mutual funds and variable annuities.
Principal-protected funds aim to do exactly what they're named: protect your principal. Some of these funds have maintained value by switching to bonds from stocks, which have plummeted 56 percent as measured by the Standard & Poor's 500 Index since October 2007.
Treasury and municipal bonds have performed much better during that period, but over the long term, stocks have outperformed bonds, so staying away from equities could be costly. That's especially the case because "the stock market's gains tend to come in spurts," says Evensky.
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Moreover, a fund could be taking risk by holding bonds with long durations. "You want to be careful how far out the yield curve you go," says James Holtzman of Legend Financial Advisors in Pittsburgh. "Interest rates are pretty much at rock-bottom. The only place for them to go is up. The longer you hold the bond, the further the price falls unless you hold it to maturity.
In addition, "the idea of safety in fixed income is more of an issue given the turmoil and volatility of the past six to 12 months," says Michael Sheldon, chief market strategist for RDM Financial Group in Westport, Conn. He notes that even municipal bonds and investment-grade corporate bonds have suffered for extended periods.
Many principal-protected funds consist of structured notes, often called principal-protected notes, issued by financial institutions. For example, "one we were looking at paid the S&P 500 return over the next 13 months, excluding dividends, capped at say 30 percent," Evensky says. "What you get in exchange for that cap is a buffer on the downside, say 15 percent. So if the S&P 500 drops 15 percent, you're even. If it drops 20 percent, you're down only 5 percent. You give the upside away to protect the downside."
The better the deal, the more careful you should be...read more