Guru Strategy: Profit from the bull while protecting your principal

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Despite the surging stock market rally this year, many investors are a bit gun shy about getting back into the market. Their nerves are still frazzled, their retirement accounts still uncomfortably low and their expenses mounting. When it comes to getting back into stocks, many -- especially those planning for retirement -- are more likely to stash their funds somewhere else, like in cash or in government bonds.

But there could be a better way to safeguard your investment while profiting from a rising market – if that ends up being the case.

To do this, Ramesh Menon, formerly a managing director and head of U.S. Equity Structured Products at Citigroup, founded his own firm, New York City-based Structured Investment Management, in 2006. His firm offers investors an open ended mutual fund that ensures that its net asset value in 10 years will be at least 120 percent (after fees) of its initial NAV, while protecting downside risk. He even build into that fund a small, minimum annualized return of 2.5 percent so at the very worst, after ten years, you get back your principal plus 2.5 percent annualized return.

"History indicates that over a 10 year period, markets are generally higher," says Menon. "But that's not always the case. What happened last year shows that markets can be lower so its prudent to have some risk management strategy in place."

You may, however, be wary of such principal protection funds. Many carry hefty fees, offer less than adequate disclosure and have been poorly designed, investing heavily in stocks in bull markets but then shifting to bonds during market downturns. That can be a problem. In 2001, for instance, after the tech bubble burst, these funds were hyped as safe ways to profit in a rising market, while safeguarding your principal. Investors poured as much as $5.75 billion into these funds. But the funds, which increasingly investing in bonds, got a bad rap after the market rebound began and investors missed out on the rally and bailed out of the funds.

Menon's principal protection fund, which only tracks the S&P 500 index, aims to higher standards. It never invests in bonds, just the index, so if there is an ensuing rally, the fund will benefit. His firm has also worked extensively with the SEC to design disclosure about not just the operating costs and expenses of the fund, but also to highlight other costs, such as hedging.

To protect the principal in the S&P 500 Capital Appreciation Fund, the fund enters into hedging contracts by buying a put option on the index. Instead of paying for the put option up front, it is paid for over time. The put options are over-the-counter options and they do have various counter parties. To avoid any credit risk associated with any seller of such an option, the put is revalued daily and the current value of that put is settled in cash on a daily basis. Instead of waiting for ten years to claim that money from the seller of the put, the Fund requires the seller to put up for the value of the put so that there is no credit risk with respect to the seller.

To further safeguard your principal, Menon's fund also requires the seller to post some initial margin or collateral to secure its performance because while the daily settlement could be as of market close today, it could drop in value over night potentially putting the sellers in default. Then they would not have enough of their money in respect to the value of the put. The Fund also buys default protection against that on the seller of the put itself.

All this protection and the promise of a minimum return of 2.5 percent comes at a reasonable price. While the fund will rise in value as the market goes up, on average it will underperform the S&P by 1.2 percent per annum. Also, dividends on the investments don't get reinvested in the Fund, but instead go to the put sellers -- part of the cost of having no downside risk and security. The resulting cost to investors is 1.16 percent in fees and 2.5 percent when you include the dividends.

Because of the built-in safety, comparing the fees here to and S&P index fund makes little sense. But you can compare the fees to, say, that of an equity index certificate of deposit with a maturity of five to 10 years. If the bank fails, you would be covered by the FDIC safeguarding your principal. But the investment is highly illiquid and should you want to take your funds out it could cost you six months in interest payments. Also, keep in mind that in such an investment, your gains are treated as ordinary income, so your taxes will be higher.

Mutual funds are also generally safe in terms of regulatory oversight, but the investment choices made by the managers could mean lousy performance even in an up market. Take target date funds, for example. Here, the fund manager sets a "glide path" for the funds' investments where the risk level for the investments made adjusts as the years go by. The result is reduced exposure to equities and increased exposure to bonds. But this can be particularly problematic because the glide path and the appropriate risk levels are based on historical information. "When the market encounters unusual circumstances, as it did last year, even if you followed the glide path your airplane still crashed," says Menon. In fact, 2010 target date funds are down about 30 percent so far this year.

Principal protection funds such as Menon's are not for everyone. If you are a young investor, or your investing horizon is long, chances are you don't need a fund such as this one. You can handle the ups and downs of the market and you can afford to take greater risks and earn a bigger return. But if you are approaching retirement, the S&P 500 Capital Appreciation Fund will let you mitigate risk and profit, should the market continue to rise.

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