Portfolio Insurance: Part 1 - Segregated Funds - Investing (Canada): 3/1/1999

Many people are clearly worried about the safety of their investments. This has led to a dazzling surge in the number of segregated funds offered by mutual fund companies. Segs used to be available only from insurance companies, but now everybody's got them. Are they worthwhile?

First, what is a segregated fund? Simply put, a segregated fund is one in which a small premium insures the fund against a loss of principal over a specified amount of time. Like mutual funds, they can be invested in bonds, equities or T-bills. They are called segregated funds because, as an insurance instrument, the assets of a segregated fund are kept apart from the other assets of the issuing company. Originally they were offered by insurance companies as a natural tie in with their business. Part investment fund and part insurance policy, these funds started to take off with the public after last year's market meltdown. The regular fund companies saw themselves losing market share to the segs and they jumped in too. But are they worth it?

That depends on you and your particular circumstances. For some people, seg funds offer special features that make them particularly attractive.

The first special feature is their guarantee of principal (ranging from 75-100%) over a set period of time, usually ten years. The second special feature is that they are also a life insurance policy, so if you die before the term is out, your beneficiary will receive the guaranteed amount or the actual value, whichever is greater. The third feature is that, because they are considered an insurance rather than an investment product, they are secure from claims by creditors. A fourth feature is that they can be reset after a gain in the market to lock in that increase. Of course the ten year term is reset from the point of lock-in as well.

Finally, there are some tax and estate planning advantages. A segregated fund with a designated beneficiary gets paid directly to the beneficiary upon the death of the unit holder, avoiding costly probate and other estate settlement fees. And while you are still alive, you can claim losses in a segregated fund held outside your RRSP against other taxable capital gains. You can't claim similar losses in a mutual fund unless you liquidate the fund.

But there are also some negatives. First, there ain't no such thing as a free lunch. Insurance policies have premiums and in the case of seg funds, it means higher management expenses, sometimes a full percentage point higher. This can add up to a considerable amount of money over time, especially with compounding. For example, Jack Lumsden in an article in Canadian Moneysaver compared the difference between having $100,000 in the AGF Dividend Fund and the Manulife AGF Dividend Segeregated Fund to Jan. 31, 1998. The results are shown in the table below:

Funds	1 Year	3 Years	5 Years
AGF Dividend Fund	$121,300	$195,781	$244,712
Rate of return	21.3%	25.1%	19.6%
Manulife AGF Div. GIF	$120,400	$191,586	$235,642
Rate of return	20.4%	24.1%	18.7%
Difference	$900	$4,195	$9,070

Your portfolio insurance for five years in this example is over $9000. A pretty stiff premium if you ask me.

A second negative is that your money is tied up for ten years if you want to claim the guarantee of principal. You might be better off bailing out of a dog after a couple of years and looking for a better investment than waiting ten years for no return at all. And the third downside is the basic question of whether they are even necessary. How likely is it that the fund will be worth less after ten years?

In fact, in a recent article in the Globe & Mail, Tony Martin reports that there have been only two ten year periods since 1926 that the Standard & Poor's 500 index has had negative returns. And the worst period, from 1928 (just before the crash) to 1938, the loss was only 0.9%. Here in Canada the TSE has posted a negative ten year return only once since 1947 - from the beginning 1965 to the end of 1974. The equivalent of the TSE 300 for that period declined from 854 to 845 or less than 1.1%.

Looking at the current data on mutual funds using the fund filter function at the Fund Library, there are only 12 Canadian mutual funds that have lost money in the last ten years. Amazingly, half of those are in the Cambridge fund family. Three of the others are resource funds, two are Japanese equity and the last is a small cap.

Segregated funds are worth examining if you are self-employed and you want to protect some assets from creditors should your business go bankrupt. Of course, this can also be accomplished to a certain extent by incorporation. People within ten years of retirement who want the upside potential of an equity mutual fund but don't want to risk the savings already accumulated may also want to consider segregated funds if the alternative is low-yield GICs.

But for the average person, the extra management expense and the long term of lock-in make it a poor choice of investment. Unless you are willing to commit to keeping your money in the same mutual fund for ten years, you should not consider it. If you should need the money before the ten years are up, you can cash out, but at the current market value. You will have paid the additional premium for nothing. And as pointed out above, the likelihod of a fund losing money over a ten year period is extremely slim, particularly if you avoid Asian and emerging markets funds, precious metals funds and Cambridge funds.

If the fund companies introduce variable terms though, segregated funds will look a lot more interesting. A seg fund with a two year maturity date would be well worth considering in a volatile market like we have today. But don't hold your breath. I don't think any fund company would consider it.

The table below summarizes the differences between seg funds and regular mutual funds.

	Segregated Fund	Mutual Fund
Maturity and Death Guarantees	yes	no
Reset Option to Lock In Gains	yes	no
Creditor Proofing	yes	no
Estate Planning Advantage	yes	no
Tax Loss Claimability	yes	no
Lower Management Fees	no	yes
Ability to Switch to a Better Investment	no	yes

Next week Part 2 of this article looks at insurance for stock market investors - namely options.

Other Links of Interest

Segregated Fund Selection - this article from Robert Mackenzie in the Canadian Moneysaver offers tips on selecting a good seg fund.

Best of Both Worlds - this feature in Profit Magazine discusses the benefits of segregated funds for self-employed entrepreneurs.

Seg Funds: Bear Market Insurance - an article by Dennis Slocum in the Globe & Mail asks the question "Is the no-loss guarantee worth the price?"

Disclaimer: As with all my columns here, I should re-iterate a precaution. I am not a professional financial advisor. I am a financial journalist and editorialist. The views in these columns are my personal opinions. The author may hold interests in a number of the investments mentioned in this article.

Next week, Part 2 of Portfolio Insurance looks at options - calls and puts. Also in the works, a look at some software designed to analyze companies that fit Warren Buffett's criteria for investment, a review of Chris Bunka's Outsider's Guide to Speculative Investing, an analysis of momentum investing, and a look at Canadian Internet Stocks.