Avoid Risk Through Insured Mutual Funds

Physician's Money Digest, June15 2003, Volume 10, Issue 11

With the significant drop in the stockmarket, the uncertainty surroundingthe US economy, the threat of futureterrorist attacks, and deflated interest rates,physician-investors are shifting their investmentconcerns. Unlike in the late 1990s when a numberof physicians were looking to hit aninvestment "home run,"most doctorssimply want to find secure investmentsthat offer upside potential. With all ofthe risks today, however, finding asecure investment can be difficult.Fortunately, it can be done.

TWO OUT OF THREE

There are 3 types of risk in anystock investment: firm-specific risk,industry risk, and market risk.Although portfolio diversification isimportant, diversifying your portfolioonly protects you against firm-specificrisk and industry risk. That ofcourse leaves you vulnerable to marketrisk. To illustrate this fact, let'slook at an example.

Dr. Correa is thinking about investingin the airline company FlyawayAir. If he purchases Flyaway stock, hisfirm-specific risks include: employees going onstrike, the CEO quitting or being arrested, aflight crash, or any other bad press or bad luckthe company may experience. If Dr. Correainvests in an airline sector mutual fund ratherthan in a specific airline company, then a drop inFlyaway's share price will not have a great effecton his total investment. Thus, Dr. Correa hasdiversified out of firm-specific risk.

However, the good doctor is still subject toindustry risk (eg, the air traffic controllerscould strike again, fuel pricescould skyrocket, or a rash of crashescould scare people from flying). Toreduce risk, Dr. Correa could spreadhis money across many industries. Hecould invest in a diversified S&P 500fund, which would be protectedagainst both firm and industry risk. Adownturn in any 1 or 2 industrieswould not significantly threaten hisoverall investment return.

THE MISSING RISK

While most advisors will discussdiversification or asset allocation asmethods of reducing risk, they areconcerned with firm and industry risk.What they typically don't offer you isprotection against market risk (ie, therisk that the market as a whole willdrop). The best they can do is haveyou spread your wealth between different assetclasses like stocks, bonds, and real estate. Let'stake a closer look at these classes.

For many reasons, real estate may not be anattractive alternative. The market could be inflated,interest rates could be high, or you just maynot be comfortable betting your retirement on aninvestment class that you know absolutely nothingabout. Furthermore, real estate is often anactive investment, requiring the landowner/landlord'stime and energy (eg, taking care of a brokenheating unit). Often, this commitment doesnot fit in very well with an investor's other timedemands, interests, and life goals.

This leaves us with corporate and governmentbonds and money market securities.Essentially, these classes of investments havereturned just 5% per year since 1926, comparedto 12% for stocks. If you look at these investmentson an inflation-adjusted basis, you will seethat you may actually lose money by investing inthese low-yielding securities.

A POSSIBLE SOLUTION

The answer:

So, do you feel as if you're in a catch-22 situationyet? You have to invest in stocks to build alarge enough nest egg to retire, but the marketrisk looms large just as the baby boomers beginretiring. Is there any way to take advantage of thestock market without subjecting your retirementsavings to substantial market risks? Yes, and it comes in the form of principal-protectedmutual funds (PPMFs).

PPMFs are mutual fund stock investmentsthat are insured against loss of principal by athird-party insurance company, if held by aninvestor for a minimum number ofyears. PPMFs are "managed"mutual fund plans. This means thata money manager utilizes combinationsof mutual funds in an attemptto maximize investor returns.

PPMFs are not easy to find,though. What makes finding a PPMFfund so difficult? An advisor must beregistered with the SEC and showevidence of an exemplary mutualfund risk management record for aperiod of at least 5 years to qualify forinsurance. Then, the advisor mustfind a company and convince it thattheir method of managing funds isworthy of their guarantee—no smalltask in today's world.

PHYSICIANS AND PPMFs

Most PPMF managers haveminimum investments of at least$50,000, although investments fallmore commonly in the range of$100,000 to $1 million and aremade within a pension or other typeof retirement plan.

If at any time during their contractan investor wants to "lock in"the appreciated amount, they cando so by beginning a new contract,which will go into effect on the newdate with the appreciated investment.In addition, an investor maywithdraw 10% of the investmentper year, as long as it is not madewithin a restricted investment vehiclelike a 401(k) or IRA. Let's lookat another example to see howPPMFs work.

On June 15, 2002, Dr. Whelanmakes a $500,000 investment in aPPMF using his existing pension (a401(k), IRA, or other retirementaccount could work as well). A warranteeis composed that states Dr.Whelan will receive the larger ofeither the appreciated value of thefund or his original $500,000 investmenton June 15, 2007. Because ofthe insurance, Dr. Whelan doesn'tneed to worry about his investmentover the next 6 months.

On December 25, 2002, Dr.Whelan decides to take a look at hisinvestment and notices that the valueof his account is now $550,000, a10% gain. Dr. Whelan then utilizesan additional benefit his PPMFoffers. He calls the fund manager andextends his contract another year.His modified contract now insureshis $550,000 against loss throughDecember 25, 2007. Since the investmentis made in a retirementaccount and cannot be withdrawnuntil age 59, there is no reason whyDr. Whelan shouldn't extend his contractafter each year the investmentappreciates. This will give him all ofthe upside of stock market investingwith no risk of lost principal.

Of course, the fees for this typeof plan are higher than the fees for aregular mutual fund portfolio. Inmost cases, the total cost of thistype of plan is only 0.5% to 1%more than a mutual fund portfoliothat doesn't have the insurance. Ifyou think paying a few extra dollars(potentially tax-deductible dollars)to reduce the risk of your investmentportfolio over time is a wiseidea, then you should further investigatethis option.

Christopher R. Jarvis

and David B. Mandell

are coauthors of The Doctor's Wealth Protection

Guide and Wealth Protection:

Build and Preserve Your Financial

Fortress (www.mywealthprotection.com). They also started the financial

firm, Jarvis & Mandell, LLC, and work with clients nationwide. They

welcome questions or comments at 888-317-9895, or visit www.jarvisandmandell.com.