NASD issued an investor warning yesterday on principal-protection funds’ higher fees, potentially lower long-term capital gains and required long holding periods.

Principal-protection funds pledge to guarantee investors’ initial investment minus any front-end sales charge in a "guarantee period" that can typically last from five to 10 years.

The Securities and Exchange Commission is said to be looking into these types of funds ( see MFMN 3/27/03).

The funds usually invest heavily in zero-coupon bonds and other high-quality debt instruments to avoid the risk of the volatile equity market and fulfill their guarantee, backed by an insurance policy, or wrapper.

Many principal-protection funds carry an expense ratio higher than regular bond funds. Fees range from 1.5% to nearly 2%, of which 33 to 75 basis points is for the principal guarantee. In addition, investors must pay a sales charge and would incur significant penalty fees for early redemption, NASD warns.

The funds’ major exposure to the debt markets may eliminate or greatly reduce any potential gains they can achieve from the subsequent gains in the stock market. They also have added risk of rising interest rates, which typically cause bond prices to fall.

Yet another drawback of such funds is that unless they are held in a tax-deferred retirement account, investors must pay U.S. income tax yearly on the interest.

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