It's the perfect sales pitch for these uncertain times: How about a chance to make money in the market, but be guaranteed you won't lose a dime?
Mutual-fund companies are racing to offer funds that promise just that. "Have you ever heard of a mutual fund that offers you the unique opportunity to participate in the market's upside potential while enjoying the added benefit of a guarantee of principal -- for five years?" reads the marketing material for ING Principal Protection Funds.
A handful of investments like the ING funds, widely known as guaranteed funds, have been around for years without garnering much attention. But the stock market's collapse is focusing attention on these offerings and bringing new versions of them out of the woodwork.
From a performance standpoint, the funds come out somewhere between stock and bond funds. Since it was launched in October 1999, the ING Classic Principal Protection Fund, for example, is down 0.2%. Meanwhile, the Standard & Poor's 500 index is down 28.8%, the average domestic diversified stock fund is down 14.2%, and the average bond fund is up 16% during the same period, according to Lipper Inc.
S&P 500 720
Nasdaq 999
Gold 400
Silver 7
Oil 35
Originally, the derivative business began as a way of insuring against risk. In the 90’s the world of derivatives turned into a business of speculation used by institutions, hedge funds and well-heeled investors to leverage their returns. The hedge funds, in particular, remain almost exclusively the domain of the wealthy. They are unregulated investment pools that aren’t registered with the SEC. They can concentrate their portfolios, use leverage, and bet the ranch without prudent concerns for diversification. When they blow-up, as in the case of LTCM, they create nuclear shock waves throughout the financial systemThe thing with derivatives is that they can create extreme profits, but with essentially unlimited risk. The problem is, for certain investers, unlimited risk does not affect them.
Suppose I have $1M in assets and I sell $1M worth of uncovered call options. If the underlying stock price goes down, the options expire without exercise and I've doubled my assets. If the underlying stock goes up, I lose money, and I may go broke.
But suppose I've sold $100M worth of options. If I win the bet, I get $100M and I retire. If I lose, I cannot lose more than my actual assets. If I lose so much that my downfall will bring the whole system down with me (as LTCM threatened to do), I no longer have a problem -- the govt does