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Paying for Protection: New Funds Aim to Capitalize on Investor Fear

Principal protection funds may <I>sound</I> good, but you end up paying dearly for this gimmick.

You already know from the movies that when a thug offers a shopkeeper "protection," it's no more than a scam.

But, thankfully, when it comes to the fund arena, you aren't strong-armed into the protection racket.

These so-called principal protection funds promise investors that they'll never lose their initial investment. That promise, though, still comes with a high price.

Basically, these funds open to new investors for a short period of time -- similar to the launch of a closed-end fund. Once that initial period expires, the "guarantee period" begins. During that time, an investor who wants to withdraw his or her money will forfeit the protected principal guarantee and frequently pay an additional fee. In other words, the principal is only protected at the end of the guaranteed period. The typical guarantee period is anywhere from five to eight years.

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Pioneer Funds is the latest to launch its version, Pioneer Protected Principal Plus. Like other funds of its ilk, the fund offers investors a hybrid portfolio of stocks, bonds and cash, backed up by an insurance contract. The fund promises investors that after the seven-year guarantee period, they'll not only get their initial investment back, but also a minimum annual return of 2% for Class A shares and 1.25% for class B and C shares. Investors have until Dec. 18 to invest in this fund. (The fund doesn't yet have a ticker; for more information see

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While principal protection and a guaranteed return sounds pretty good, you really ought to have learned by now that when it comes to new investing trends (like most things), if it sounds too good to be true, it probably is.

First of all, these funds are almost unbelievably expensive. "There's an insurance company backing up that guarantee," says Morningstar mutual funds analyst Emily Hall. Oh, and by the way -- your principal is protected



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You already know that high fees are the fastest way to negate the long-term return of a fund. Pioneer Protected Principal will charge between 2.1% and 2.85%, depending on the share class. That's nearly 70% higher than the expense ratio of the typical domestic hybrid fund, according to Morningstar. It's also a little higher than other principal protected funds, which generally charge more like 1.75%.

More Bad News

Those high fees are primarily due to the insurance contract that wraps the fund (much the same way annuities are more expensive because of the insurance wrapper). Adding insult to injury, though, is what these funds invest in.

Managers can alter the allocation of these funds as they see fit -- moving more into equities as the market begins to recover, for instance. But they generally hold the bulk of their assets in cash and bonds. You can certainly find a money market fund that will protect your principal and charge less than 1% to do it; ditto for a bond index fund. And neither of those offerings will penalize you for withdrawing your money whenever you need it.

As for the equity portion of the portfolio, these funds generally stick to large-cap blue-chip companies. (One exception is the


Smith Barney Capital Preservation fund, which has the freedom to enter the small-cap realm.) Again, you can own an

S&P 500

index fund for far less.

A number of principal protection funds have hit the market this year, including Smith Barney's Capital Preservation fund,


ING Principal Protection II and III, and Idex Principal Protected Stock (no ticker yet). But don't confuse increased availability with a sound investing decision. Individuals are almost always better off developing an asset allocation plan, finding low-cost investment options and sticking with them. The shifting allocation and high cost of principal protected funds make them unappealing investments -- no matter how skittish the market has made you.

"Gimmicky funds driven by a particular market condition are generally problematic investments," Hall says. "And that's certainly the case with principal protected funds."