What it means
Many people want some stock market growth without the risk of losing what they put in. Protected funds, also called capital-protected or guaranteed funds, try to meet that need by combining a safe component with a growth component.
The safe part, often a bond or deposit, is set up to grow to the protected amount at maturity, and the remainder is used to buy exposure to a market, usually through options. The protection level is stated in the fund's documents, for example 90% or 100% of the original investment.
It normally applies only at the end of the fixed term, which might be five or six years. If an investor sells early, the price depends on market conditions and may be below the amount originally invested.
The growth is typically limited by a participation rate, which says what share of the market's gain the investor receives. A 60% participation rate means that if the index rises 30%, the investor receives 18%.
Some funds also cap the maximum return or use averaging that reduces the gain, so the terms should be read carefully. There is no free lunch.
The cost of protection comes from fees, from the lower returns on the safe assets that are held, and from giving up part of the upside. There is also counterparty risk, since the guarantee is only as strong as the bank, insurer or other party that provides it.
Whether a protected fund is suitable depends on the investor's goals and time horizon. For some, the peace of mind of a floor is valuable.
For others, a plain mix of bonds and shares may offer similar protection at lower cost, and inflation can eat into the real value of a fund that only returns the original capital.
In practice
Real-world examples.
Example
A retired couple invests $200,000 in a five-year protected fund that guarantees 100% of capital. The market has a poor period, and at maturity they receive their $200,000 back, though inflation has reduced its purchasing power.
Example
A cautious investor puts $50,000 into a fund with a 90% protection level and a 70% participation rate. If the index rises 20%, she gets $50,000 x [0.90 + 0.70 x 0.20] = $52,000, and if it falls she receives at least $45,000.
Example
A finance manager at a charity reviews a protected fund and notices that the guarantee comes from a single bank. She asks the board to consider the bank's credit strength, because the protection would be worth less if the bank failed.
Formula
Calculation
The payout at maturity for a simple protected fund is:
Maturity value = Investment x [Protection level + Participation rate x Maximum (0, Index return)]
Suppose an investor puts in $100,000 for five years in a fund that protects 100% of capital and has a 60% participation rate.
If the index rises 30% over the period, maturity value = $100,000 x [1.00 + 0.60 x 0.30] = $100,000 x 1.18 = $118,000.
If the index falls 20%, the maximum of 0 and the return is 0, so maturity value = $100,000 x [1.00 + 0] = $100,000.
Over five years, an $18,000 gain is 18% in total, which is far less than the 30% rise of the index, and a return of $0 would be a real-terms loss if inflation was positive.Case study
Seen in the real world.
Greystone Wealth is an illustrative, fictional adviser whose client, a cautious investor named Ms Ahmed, wanted market exposure without risk to her $120,000 savings. The adviser proposed a six-year protected fund guaranteeing 100% of capital, with 50% participation in an index.
Ms Ahmed compared it with a simple alternative of putting $60,000 in a deposit and $60,000 in an index fund. The adviser explained that the protected fund gave a firm floor, but its participation rate meant she would capture only half of any rise.
She decided to split her money between the two approaches, with $60,000 in the protected fund. The illustrative lesson is that protection is a trade-off, and the investor should weigh the cost in lost growth against the comfort of the guarantee.
Watch out
Common mistakes.
- Assuming the guarantee applies at any time, when it normally applies only at maturity of the fixed term.
- Overlooking counterparty risk, which means the protection depends on the financial strength of the guarantor.
- Focusing on protection and ignoring the cost in lower participation, fees and the effect of inflation on the returned capital.
Questions
People also ask.
Is my money fully safe in a protected fund?
It is protected to the level stated in the documents if the guarantee is honoured and you hold to maturity, but it is not the same as a bank deposit covered by a government scheme.
What is a participation rate?
It is the percentage of the index's gain that the investor receives, so a 60% rate turns a 10% market rise into a 6% return.
Can I withdraw early?
Usually yes, but the protection often does not apply, and the amount received may be lower than the original investment.
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